A Multifactor Approach in Understanding

Asset Pricing Anomalies

An empirical study of the factor model in the
Budapest Stock Market
Naffa Helena
Spring 2009
Budapest
Table of Contents
Table of Figures................................................................................................................... 3
Tables....................................................................................................................................3
1 Introduction....................................................................................................................... 5
2 The Efficient Market Hypothesis.....................................................................................6
2.1 Theory......................................................................................................................................... 7
2!! "eak #orm of $fficiency%
2!2 Semi&Strong #orm of $fficiency%
2!' Strong #orm of $fficiency%
2.2 The Hypothesis Defied.............................................................................................................. 10
2.3 Capital Asset Pricing Model.....................................................................................................12
2.4 An Alternatie Theory! Ar"itrage Pricing Theory.....................................................................14
2.# $elationship "et%een the CAPM and APT................................................................................1&
2.& 'hen Theories (ail) Ano*alies Preail....................................................................................1&
2(! )he *alendar $ffect!+
2(2 $arnings on Book $,uity2!
2(' P-$ $ffect 22
2(. Small&#irm $ffect22
2(/ 01er and Under 2eaction to $arnings2'
2(( Mean 2e1ersion2.
2(+ )he Momentum $ffect2/
2(% 0ther Anomalies 2+
2.7 Ca+ses of the Ano*alies...........................................................................................................30
3 Behavioural Finance....................................................................................................... 32
4 Anomalies: Premium or Inefficiency............................................................................. 33
4.1 A Test to the CAPM................................................................................................................... 34
4.2 M+ltiple (actors ....................................................................................................................... 3&
.2! Market *apitalisation and the 3alue Premium'%
4.3 Three (actor Model of (a*a and (rench.................................................................................40
4.4 Characteristics Model of Daniel and Tit*an............................................................................42
5 Empirical Findings of the Budapest Stock Exchange.................................................. 45
/!! *alculating 4eta and mean return./
/!2 #orming Portfolios .9
/!' )he #actors5 Market Premium6 SMB and HM7/'
/!. #ama8s model tested on the Budapest Stock $9change//
6 Limitations of the Study................................................................................................. 59
2
7 Conclusion........................................................................................................................60
References.......................................................................................................................... 62
Appendix 1......................................................................................................................... 66
Appendix 2......................................................................................................................... 68
Table of Figures
Figure 1: Haugens monthly returns for years 1927-2001 .............................................18
Figure 2 Mean reverting and non-mean reverting behaviour ...................................... 24
Figure 3: CAPM mean excess returns plotted against beta. ........................................ 36
Figure 4: Empirical beta for BUX components, calculation period 1996 -2007...........47
Figure 5: Reuters beta for BUX components, calculation period 5 years.....................47
Figure 6: Empirical beta (x axis) graphed against stock return (y axis), period Sept.
2004 Sept. 2008................................................................................................................ 48
Figure 7: Reuters beta (x axis) graphed against stock return (y axis), period 5 years
from 2007............................................................................................................................ 49
Figure 8: Mean excess returns vs. market beta, varying size and book/market ratio 51
Figure 9: Varying size within book-to-market equity ratio groups. ............................52
Figure 10: Varying book-to-market equity ratio within size groups.............................52
Figure 11: BUX yearly return and the 3 month government bond yield from
February 1997 to March 2008........................................................................................... 53
Figure 12: Market premium is shown by the excess return over the risk free rate.....54
Tables
Table 1: The first periods regression January 1991- December 1997 .........................19
Table 2: The second periods regression January 1998 December 2004................... 20
'
Table 3: Summary Statistics for Monthly Percent Three-Factor Explanatory Returns
.............................................................................................................................................. 41
Table 4: Regression Results for the Characteristic-Balanced Portfolios ..................... 44
Table 5. Returns of the 16 BUX constituent stocks, their betas calculated using yearly
yields projected on 1 day, and their Reuters beta. Calculation period 1996 2007. . .46
Table 6: Stock returns, betas calculated using yearly yields projected on 1 day,
Reuters beta. Calculation period September 2004 Sept. 2008................................... 48
Table 7: Correlation matrix of the factors HML and SMB
.............................................................................................................................................. 55
Table 8: Granger causality test for the factors HML and SMB.................................... 55
Table 9: Summary table of regression of the 3 factors on the 23 Hungarian shares...58
.
,'hat is a cynic- A *an %ho .no%s the price of eerything) and the al+e of nothing./
0scar "ilde : 7ady "indermere8s #an
1 Introduction
An anomaly is usually a disorder6 a de1iation from the norm ;n natural science6 it has
induced researchers to formulate ne< theories ;n finance ho<e1er6 <hat could not 4e
e9plained 4y traditional asset pricing theories
!
<as hastily ar4itrated6 and later la4elled an
anomaly )he multifactor model de1ised 4y #ama and #rench on the other hand6 is ,uite
successful in e9plaining these anomalies6 and therefore6 the ne< theory is a4le to
incorporate them in their asset pricing formula
;n my thesis6 ; introduce the topic of o4ser1ed a4normal
2
market returns as 4eing =ustifia4le
premiums 1ersus signifying market inefficiencies )he phenomenon of anomalies is 4est
e9plained 4y an amalgam of a1aila4le financial literature ;n such an e9planation6 the
$fficient Market Hypothesis plays a central role in defining a standard for asset pricing in
an ideal <orld ; <ill introduce the capital asset pricing model approach ;n contrast <ith
this6 ; discuss an e9tended model de1ised 4y #ama of asset pricing that incorporates factors
relating to the anomalies discussed )his <ill familiarise the reader <ith the
methodologies applied 4y different theorists to test the ne< model against traditional
approaches )he critics of the ne< #ama model re4uke <ith an apparent rationale5 the ne<
model is specific to the set of data e9amined 4y #ama> therefore its high precision in
forecasting asset returns is not a coincidence ; shall attempt to re1eal the rele1ance of the
model to the Hungarian market My approach <ill apply the formula to the emerging
Budapest Stock $9change shares using an un&am4itious time series from Septem4er 200'
till Septem4er6 200%
!
)raditional asset pricing theories co1er the *APM and the factor model ?AP)@
2
A4normal returns denotes returns e9ceeding market yield6 ie ?ri&rm@
/
012d "e a "+* in the street %ith a tin c+p if the *ar.ets %ere efficient.0
"arren Buffett
2 The Efficient Market Hypothesis
Aespite the a4o1e ,uote from "arren Buffett6 ; <ith to study informational efficiency in
stock markets "hen markets are efficient6 they <ork smoothly <here4y the possession of
ne< information causes no added&1alue #rom this stems the assumption in financial
models that additional information should come at no cost6 as it is already reflected in
prices ;t is much ore likely to ha1e transparent pricing for financial instruments traded on
stock markets eg stocks6 4onds6 commodities But the matter of fact is that the efficient
market hypothesis fails in practice ;n1estments traded on the stock market 4y far do not
represent to complete in1estment portfolio a1aila4le to in1estors 0ther financial products
are a1aila4le on different platforms6 most of <hich are less transparent than stock markets
)he efficient market hypothesis ?$MH@6 ho<e1er6 makes assumptions that limit its 1alidity
to a theoretical market Amongst these assumptions is that all transactions are transparent6
<hich makes pricing fair ?un4iased@6 as they incorporate all a1aila4le information
including the e9pectations of the market participants of the future shaping of the market
;nformation6 as defined 4y the theory6 is anything that affects prices in a <ay unkno<n in
the present appearing randomly in the future #or this reason6 it is not possi4le to
consistently outperform the market 4y taking ad1antage of ne<s the market already kno<s6
e9cept <hen an in1estor is lucky
)he efficient market hypothesis <as first coined 4y 7ouis Bachelier6 a #rench
mathematician ;n his !900 dissertation B)hCorie de la SpCculationD he B4egins the
mathematical modelling of stock price mo1ements and formulates the principle that Ethe
e9pectation of the speculator is Fero8 041iously6 he understands here 4y e9pectation the
conditional e9pectation gi1en the past information ;n other <ords6 he implicitly accepts as
an a9iom that the market e1aluates assets using a martingale measureD ?*ourtault et al
(
2000 p '.'@ Get his <ork <as o1erlooked for decades until the mid !9(0s <hen Paul
Samuelson stum4led upon the dissertation and soon it 4ecame a hot topic for financial
economists Ho<e1er6 the efficient market theory o<es its refined details to Professor
$ugene #ama of the Uni1ersity of *hicago Hraduate School of Business #ama started the
formation of the theory as a PhA dissertation and ended up as a life&long research ;n
!9+0 he pu4lished a re1ie< of 4oth the theory and the e1idence for the hypothesis )he
paper e9tended and fine&tuned the theory> in addition6 it included the definitions for three
forms of market efficiency5 the <eak6 the semi&strong and the strong form of market
efficiency
2.1 Theory
)he theory assumes that market participants apart from 4eing utility ma9imising6 also ha1e
rational e9pectations )his includes the assumption that e1en though indi1iduals may 4e
<rong6 the population as a <hole is correct> and that people ad=ust their e9pectations
according to ne< information "hen faced <ith ne< information6 some in1estors <ill
o1erreact and others <ill under react ;n summery6 reactions <ill 4e random6 4ut <ill ha1e
a constant 1olatility6 and a kno<n distri4ution function )hus6 the net effect does not allo<
for a4normal profit to 4e realised especially <hen considering transaction costs and
spreads
#ama says that an efficient market is one that ,uickly ad=usts to ne< information ;t
pre1ails in markets <here prices Bfully reflectD a1aila4le data )his constitutes the
impossi4ility of attainting e9tra profits 4y trading on the 4asis of kno<ledge of information
already incorporated
;t means that in its strongest form6 there should 4e no cost of information "e kno< that
this in untrue6 and that a <hole industry is 4ased on selling information )his is <hy the
need arises to further define efficiency of the markets )his has taken the form ' le1els of
information integration> the <eak form of efficiency6 the semi&strong form of efficiency
and the strong form of efficiency are discussed 4elo<
+
2.1.1 Weak For of Efficiency
;n its <eakest form6 the efficient market hypothesis assumes that all historical share prices
are already incorporated into the pricing of assets )herefore6 no e9cess profits can 4e
earned 4y 4asing in1estment strategies on past returns )his implies that technical
analysis6 <hich studies formations in past returns6 is useless in predicting the future Since
past performance is already kno<n to the market6 the current situation remains unkno<n
)his is <here fundamental analysis gains attention and may 4e re<arding for those keen
in1estors <ho do their home<ork on companies8 financial statements
)ests for the <eak form of efficiency engage in historical data analysis using statistical and
econometrical methods Analyses concerning market 1alue6 P-$6 A;3-P6 and 4ook&e,uity&
to&market&e,uity influences on past data6 as <ell as technical analysis are pre1alent in such
testing
2.1.2 !ei"!trong For of Efficiency
)he le1els of efficiency gradually increase their restrictions6 so it is natural for the ne9t
le1el to include the pre1iously stated assumptions ;n addition to historical data6 the semi&
strong form of efficiency incorporates pu4licly a1aila4le ne< information rapidly into
pricing> this insinuates that fundamental analysis <ill yield nothing
)esting for semi&strong form of efficiency is similar to e1ent studies $mergence of ne<
information usually takes the form of ,uarterly or annual reports or e1ents such as mergers6
ac,uisitions6 purchase of treasury shares6 ne< issuances or splits )he emergence of such
ne<s should induce markets to adapt ,uickly "e can measure the ,uickness and flo< of
the adaptation to ne< information
2.1.# !trong For of Efficiency
)his le1el of efficiency constitutes the incorporation of all e9isting information6 4oth
pu4lic and pri1ate6 into prices ;n such a model no one can earn e9tra profits 0f course in
reality la<s prohi4it trading using insider information )he Hungarian *apital Market 7a<
%
?)pt *II-200! J !99&20/@ prohi4its trade using information not kno<n to the pu4lic ;n
the United States the ;nsider )rading Sanctions Act of !9%. and the ;nsider )rading and
Securities #raud $nforcement Act of !9%% regulates penalties for illegal insider trading Bto
4e as high as three times the profit gained or the loss a1oided from the illegal tradingD
'
2ele1ant la<s in the United Kingdom also re1eal a similar standpoint )he #inancial
Ser1ices Act !9%( and the #inancial Ser1ices and Markets Act 2000 define an offence of
Market A4use
)esting the strong form is a test for the e9istence of insider trading "e attempt to re1eal
the in1estment acti1ity of interest groups <ith monopoly o1er key decisions in the
companies )his can 4e o4ser1ed in price ad=ustments taking place 4efore important
announcements are made pu4lic
'
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th
August6 200%
9
,Mar.ets can re*ain irrational longer than yo+ can re*ain solent./
Lohn Maynard Keynes
2.2 The Hypothesis $efied
2esearchers argue a4out the 1alidity of the efficient market hypothesis in the real markets6
especially its strong form )he main set&4ack to the theory includes slo< transmission of
information6 and relati1e po<er of a fe< market players )he market8s mechanism in
adapting to change in interest rates for instance6 takes from a fe< hours to se1eral <eeks
)his is the main defect6 <hereas according to the $MH this process ought to 4e
instantaneous 0nly a fe< pri1ileged people may ha1e prior kno<ledge of ne< la<s or
decisions that <ill affect prices As long as actors on Einside information8 ar4itrate market
mispricing in a discreet manner6 they can a1oid 4eing detected As soon as such trading
takes place on a <ide scale6 <e cannot dismiss it from our study as random 1aria4les
Another malefficiency of the real markets compared to the ideal suggested 4y $MH is that
at e9treme situations <hat fundamentalists consider irrational in1estor 4eha1iour is
actually the norm As an instance6 the last stage of a 4ull market is usually dri1en 4y
4uyers ?speculators@ <ho take little consideration of the underlying 1alue of the asset
*ontrarily6 the end of a 4ear market <itnesses a free fall as e1ery4ody attempts to close
their positions regardless of the ,uality of the in1estments they hold )his o4ser1ation is
4olstered 4y the differences in stock 1aluation in 4ull markets compared to 4ear markets
)hus6 it <ould make sense for rational in1estors to take ad1antage of the feigned high or
lo< prices caused 4y irrational participants6 4y taking on opposite positions 041iously in
practice this is insufficient to pre1ent arising 4u44les or crashes 2ational in1estors are
a<are of the irrational 4eha1iour of the market6 and at e9treme times6 they <ill need
reasons superseding fundamental e9planations to con1ince them that the market <ill return
to<ards fair 1alue ;t <as sho<n statistically6 that e9treme 1alues do occur more often
!0
than a normal distri4ution <ould anticipate And these e9treme 1alues are not confined to
three sigmas
.
> a phenomenon financial literature refers to as a distri4ution8s fat tail
0pponents of the theory argue that there e9ists a small num4er of in1estors <ho managed
to sustain their outperformance of the market for long periods of time6 in a <ay that
o1errules the role of luck )hese include names such as Peter 7ynch and "arren Buffett
)heir strategies <ere al<ays to identify markets <here prices did not fully reflect a1aila4le
information 0n the other hand6 proponents of the theory argue that $MH does not rule
out the success of a limited num4er of funds through chance #urthermore6 these
e9planations go on to e9plain the success of Estar8 fund managers as 4eing the result of
management skills rather than stock market prediction
Malkiel is a famous supporter of the general 1alidity of the efficient market hypothesis
$1en he6 4ased on empirical findings6 4elie1es that some emerging markets for e9ample
the *hinese markets6 are not efficient Malkiel <arns that Bthe Shanghai and ShenFen
markets e9hi4it su4stantial serial correlation in price trends and e1idence of manipulation6
contrarily to the random <alk theory that is e9pected from markets in the United StatesD
?Malkiel 200' p 2'@
Moreo1er6 the efficient market hypothesis appears to 4e inconsistent <ith some e1ents in
stock market history e1en in the United States )he market crash of !9%+ <as caused 4y
no ma=or ne<s> and despite that the Monday of the crash sa< the SMP /00 inde9 fall more
than 20N only in the month of 0cto4er )he decline seemed to originate from no<here6
only the irrational 4eha1iour that caused the haphaFard s<eep through stock markets6
Malkiel continues
;n1estment culture in the pu4lic8s imagination also refuses the efficient market hypothesis
)his may 4e attri4uted to a general misconception concerning its meaning Many 4elie1e
that $MH states that a security8s price is a correct reflection of the 1alue of the underlying
company as calculated 4y discounting the future returns ;f this <ere true6 it <ould mean
that a stock8s price accurately en1isages future results Since this is e1idently not the case6
many people re=ect the hypothesis Ne1ertheless6 $MH does not attempt to predict future
.
Sigma is standard de1iation A4out 99+N of a normal distri4ution NO?06!@ is confined to three sigmas
!!
returns 2ather6 the $MH states that a security8s price incorporates possi4le pro=ections of
future happenings6 4ased on the 4est information a1aila4le at the time )he $MH merely
estimates the performance of a stock ;f the course of e1ents 1eers the true 1alue of the
stock too far a<ay from the $MH prediction6 e1en then the de1iation does not challenge
the 1alidity of $MH
2.# Capital %sset &ricing Model
So far6 <e discussed price changes in singular share portfolios 0n the other hand6 <hen
an in1estment portfolio includes more than one type of instrument6 then the relati1e pricing
to each other steps in as a determining factor #inancial theory accepts the notion that a
share8s return should 4e proportional to the risk incurred 4y its holder Because
differences in e9pected returns of different in1estment opportunities reflect different le1els
of risk6 <e are in need of an e,uili4rium model At the 4irth of the efficient market
hypothesis6 the risk&return e,uili4rium model <as the *APM6 a de1elopment of Sharpe
and 7intner
)he *apital Asset Pricing Model assumes in1estors to 4e utility ma9imising agents ;t also
assumes that all in1estors 4eha1e in the same manner )hus6 4y aggregating utilities6 a
securities market line ?SM7@ can 4e defined and an optimal in1estment portfolio can 4e
determined )he *APM incorporates t<o types of returns6 the risk free returns of the
go1ernment 4onds and 4eta times the return on the market portfolio )he follo<ing
e,uation is the 4asis of this model5
P @ ? Q @ ?
f * f i
r r 3 r r 3 + =
<here
@ ?
i
r 3
is the e9pected return of the asset in ,uestion> f
r
is the risk free return rate>
*
r
4eing the market risk> and

the sensiti1ity of the particular share to mo1ements in

the market return #ormally6

8s definition is5
!2
2
@ 6 ?
*
* i
i
r r Co

=
<here
i
r
is the return of the asset6
*
r
is the return of the market portfolio6 and
2
*
is the
1ariance of the market portfolio
)his form of the *APM is a specific case of the more generalised form5
i f * i i
r r 3 r 3 + + = P @ ? Q @ ?
)he a4o1e linear regression pro1ides a method for estimating i

the mispricing of the

stock relati1e to the market> and

the stock sensiti1ity to the market risk factor> and i

the residual return

Acti1e portfolio managers seek to gain incremental returns <ith a positi1e alpha6 4ut if
markets are efficient and the Sharpe&7itner 1ersion of the *APM is the correct model6 then
alpha ought to 4e Fero Statistical inference to test the hypothesis RS0 is the 4asis of many
empirical tests of the 1alidity of different 1ersions of the *APM
Sharpe recei1ed the No4el memorial priFe in !990 for his <ork on the *APM6 this is <hen
his Sharpe ratio gained popularity )he ratio descri4es ho< much e9cess return the
in1estor is recei1ing for the e9tra 1olatility that he is enduring for holding a riskier asset
4
f 4
r r
4 5

@ ?
@ ?

=
<here 9 is the in1estment6 r
9
is the a1erage rate of return of 96 r
f
is the risk&free return and
4

is the standard de1iation of r?9@

)he <eakness of the ratio is that it assumes that all asset returns are normally distri4uted
A4normalities like kurtosis6 fatter tails and higher peaks6 or ske<ness on the distri4ution
can 4e a pro4lematic for the ratio6 as standard de1iation doesnTt ha1e the same
effecti1eness <hen these pro4lems e9ist
!'
,An econo*ist %as strolling do%n the street %ith a co*panion %hen they co*e +pon a
6100 "ill lying on the gro+nd. As the co*panion reached do%n to pic. it +p) the
econo*ist said 7don8t "other 9 if it %as a real 6100 "ill) so*eone %o+ld hae already
pic.ed it +p8./
Andre< 7o ?2000@
2.' %n %lternati(e Theory) %rbitrage &ricing Theory
A su4stitute and concurrent theory to the *APM is one that incorporates multiple factors in
e9plaining the mo1ement of asset prices )he ar4itrage pricing model ?AP)@ on the other
hand approaches pricing from a different aspect ;t is rarely successful to analyse portfolio
risks 4y assessing the <eighted sum of its components $,uity portfolios are far more
di1erse and enormously large for separate component assessment6 and the correlation
e9isting 4et<een the elements <ould make a calculation as such untrue 2ather6 the
portfolio8s risk should 4e 1ie<ed as a single product8s innate risk )he AP) represents
portfolio risk 4y a factor model that is linear6 <here returns are a sum of risk factor returns
#actors may range from macroeconomic to fundamental market indices <eighted 4y
sensiti1ities to changes in each factor )hese sensiti1ities are called factor&specific 4eta
coefficients or more commonly6 factor loadings ;n addition6 the firm&specific or
idiosyncratic return is added as a noise factor )his last part6 as is the case <ith all
econometric models6 is indispensa4le in e9plaining <hate1er the original factors failed to
include ;n contrast <ith the *APM6 this is not an e,uili4rium model> it is not concerned
<ith the efficient portfolio of the in1estor 2ather6 the AP) model calculates asset pricing
using the different factors and assumes that in the case market pricing de1iates from the
price suggested 4y the model6 ar4itrageurs <ill make use of the im4alance and 1eer pricing
4ack to e,uili4rium le1els At its simplest form6 the ar4itrage pricing model can ha1e one
factor only6 the market portfolio factor )his form <ill gi1e similar results to the *APM
!.
Stephen 2oss6 <ho initiated AP) in !9+(6 e9plained that an asset8s price today should
e,ual the sum of discounted future cash flo<s6 <here the e9pected return of the asset is a
linear function of the 1arious factors According to this definition6 risky asset return <ill
satisfy the follo<ing e,uation5
n in i i f i
$P $P $P r r 3 + + + + = @ ?
2 2 ! !
i n in i i i i
( ( ( r 3 r + + + + + = @ ?
2 2 ! !
"here
@ ?
i
r 3
is the e9pected return of the asset6
n
$P
is risk premium of the factor6 f
r

the risk&free rate6
n
(
the factors6
in

is the sensiti1ity of the asset to factor n6 also kno<n

as factor loading6 and
i

is the asset8s idiosyncratic risk

#actors may 4e economic factors ?such as interest rates6 inflation6 HAP@ financial factors
?market indices6 yield cur1es6 e9change rates@ fundamentals ?like price-earnings ratios6
di1idend yields@6 or statistical ?eg principal component analysis6 factor analysis@ )he
factor model8s 4eta coefficients ie sensiti1ities may 4e estimated using cross&sectional
regression or time series techni,ues
"ell&di1ersified portfolios are assumed in the model )his incorporates that U the
distur4ance factor 4e composed of sufficiently uncorrelated terms so that the distur4ance
term for a su4stantially large portfolio 1anishes )he market portfolio <ill 4e <ell&
di1ersified if no single asset accounts for a significant proportion of aggregate <ealth A
further assumption is that there is perfect competition in the market6 and that factors do not
outnum4er the assets in the portfolio in order to a1oid the pro4lem of matri9 singularity
"hat is the conse,uence in the case returns de1iate from <hat the model pro=ectsV )he
name of the model suggests ar4itrage Ar4itrage is taking ad1antage of a state of
im4alance in a market thus attaining risk free profit )<o kno<n approaches of ar4itrage
are cited in Makara ?200(@ p 25
)here is no static ar4itrage if there is no such
:
4 <here6
!/
0 > ;4 and
0 T 4 p
?!@
0r 0 ;4 and
0 T < 4 p
?2@
;f there e9ists
:
4 for <hich e,uation ! is true then there is type ! of ar4itrage ;t
means that an ar4itrageur has the chance of gaining money in the future6 4ut it costs him
nothing at present ;n case there is such an
:
4 <hich satisfies e,uation 26 then
ar4itrage of type 2 steps in ;n plain <ords6 it means that the ar4itrageur <ill recei1e
money at present <ith no prospects of losing in the future
)he mechanism of ar4itrage constitutes that in1estors trade at least t<o assets> one of them
is mispriced according to the model )he relati1ely e9pensi1e asset is sold to finance the
purchase of the relati1ely cheap asset )he correctly priced asset may 4e a synthetic
product6 <hich is a portfolio of other correctly priced assets com4ined to reproduce the risk
and the return of the original asset )he synthetic product should ha1e the same e9posure
to each of the factor of the AP) model as the asset it <ishes to reproduce
2.* +elationship bet,een the C%&M and %&T
)he t<o models approach asset pricing from different aspects )he AP) is less restricti1e
in its assumptions than the *APM ;t is a rather e9planatory model as opposed to
statistical ;t assumes in1estors <ill each hold a portfolio uni,ue to their risk recepti1eness
<ith a uni,ue 4eta6 as opposed to the identical market portfolio presumed 4y the *APM
Moreo1er6 the AP) presumes an infinite num4er of in1estments6 <hich in turn lead to the
disappearance of firm&specific risk ;t can 4e 1ie<ed as a supply&side model6 as its 4eta
coefficients reflect sensiti1ity of the underlying asset to the different factors ;n this sense6
factor changes <ill cause siFa4le shifts in the asset8s e9pected returns 0n the other hand6
the *APM is a demand&side model ;ts results arise from the in1estors8 utility function
ma9imisation pro4lem6 and from the resultant market e,uili4rium As in1estors can 4e
considered to 4e consumers of the asset6 the demand approach is reasona4le
2.- When Theories Fail. %noalies &re(ail
!(
Since researchers recognised the e9istence of asset mispricing that surpassed a1aila4le
economic theories8 a4ility to e9plain them6 the study of anomalies 4egan ;t is al<ays
easier to determine the causes of the occurrences <ith the 4enefit of hindsight But <hen
they are actually taking place6 it is not easy to identify them6 let alone incorporate them
into pricing models )his is the 4enefit market speculators get for their efforts in
identifying anomalies "hen an anomaly gets detected6 and enough ar4itrageurs ha1e
made money6 as the self&fulfilling prophecy foretells us6 the trend disappears )his is <hen
the anomaly is ripe for pu4lic introduction and the race 4egins for pro1iding e9tensi1e
analysis in financial =ournals Amongst the reasons for anomalies are5 ta9 e1asion6
<indo<&dressing of portfolio fund managers6 or e9pected premium for trading opposite
positions to insiders Here6 ; introduce the most famous anomalies that pre1ailed in the
past decades
2.-.1 The Calendar Effect
)he calendar effect incorporates se1eral o4ser1ances related to the calendar schedule
2ises and falls that <ere o4ser1ed on specific days of the <eek or on months of the year
0ften calendar&related anomalies are related to prescheduled deadlines of corporate
lia4ilities or simply to sociological ha4its of in1estors
)he most common is the <an+ary effect or in other <ords end&of&year effect ;t <as
noticed from the mid !9(0s that at the end of each year6 prices of stocks fell noticea4ly6
<ith no reasoning found in the fundamentals of the companies ;t <as found that 4efore
the end of the fiscal year on '!
st
Aecem4er6 for ta9 optimising purposes6 in1estors closed
their positions to realise their losses Haining positions <ere closed for reasons of 4oosting
fund managers8 report figures6 and thus their end&year 4onuses )he resultant selling
pressure caused prices of assets to fall )he first days of the Ne< Gear6 hence6 <ere
suita4le for these in1estors to 4uy 4ack6 or for others <ho sa< an opportunity in the lo<
Aecem4er prices to 4uy )his tendency caused a =ump in prices in the first fi1e days of
Lanuary each year6 and6 therefore 4ecame kno<n as the Lanuary effect ;t is interesting to
notice that this effect mainly affected small cap stock 2o4ert Haugen measured monthly
returns in stocks from !92+ : 200!6 his findings are 1isi4le in the 4ar chart 4elo< ?Source5
!+
Haugen8s chart taken from http5--en<ikipediaorg-<iki-LanuaryWeffect do<nloaded /th
Septem4er6 200%@
#igure !5 Haugen8s monthly returns for years !92+&200!
After the Lanuary effect 4ecame <idely kno<n to the pu4lic6 it slo<ly shifted to Aecem4er6
causing the so&called Santa *laus rally But soon6 the anomaly disappeared )he Monday
effect <as slightly less o41ious ;t <as o4ser1ed that stocks traded on Monday <ill follo<
the pre1ailing trend from the pre1ious #riday #or e9ample6 if the market <as in an
up<ard trend on #riday6 it should continue on Monday <here it left off and resume its rise
Moreo1er6 Monday returns did not reflect the <eekend days8 return of capital> markets
seemed not to count the <eekend in calculating returns Hence the notion6 that <hen
turning daily return to yearly and 1ice 1ersa6 the multiplier in this case is 2/0 <orking days
as opposed to '(/ days of the year
Lulia )XmYri ?200/@ studied the calendar effect on the Budapest Stock $9change for the
period Lanuary6 !99! to Aecem4er 200. )he methodology included the use of dummy
1aria4les to represent days of the <eek as the follo<ing e,uation suggests5 ?)XmYri 200/ p
2'@
!%
t t t t t t t
D c D c D c D c D c r + + + + + =
/ / . . ' ' 2 2 ! ! 6 <here5
t
r
is the logarithmic return of the asset on day t
6 6
2 ! t t
D D
5 are dummy 1aria4les6 ie t
D
! takes on ! if t is a Monday6 other<ise it takes
on the 1alue of Fero
)he testing period <as di1ided into t<o inter1als for the follo<ing reasons )he first
period from Lanuary6 !99! : Aecem4er !99+ <itnessed the re&opening of the Budapest
Stock $9change )he initial phase <as sta4le yet immature )he regression sho<ed t<o
days <ith significant determining po<er o1er the shaping of returns "ednesday and
#riday <ere the ones <ith determining po<er6 and Monday <as merely on the 1erge of
reaching the !0N significance le1el Surprisingly6 all days yielded positi1e returns as
sho<n in ta4le ! )he star indicates significant results at a !0N significance le1el> the
dou4le stars indicate significance at /N ?Source5 )XmYri 200/ p 2.&2/@
)a4le !5 )he first period8s regression Lanuary !99!& Aecem4er !99+
)he years follo<ing the regime&change sa< high inflation6 <hich induces the
reconsideration of nominal returns
;n the latter phase that co1ers Lanuary !99% to Aecem4er 200.6 daily a1erage returns do
not significantly de1iate from Fero6 <hich means that the market is efficient Moreo1er6
<e o4ser1e negati1e returns on some of the days ?Source5 )XmYri 200/ p 2/@
!9
)a4le 25 )he second period8s regression Lanuary !99% : Aecem4er 200.
Bet<een !99+ and !999 1olatility of the returns <as considera4le6 in 4oth positi1e as <ell
as negati1e directions )his <as primarily the conse,uence of the 2ussian crisis that
especially affected the Hungarian pharmaceutical companies 7ater6 contagion reached the
Asian )igers #rom the test results6 <e can deduce that the Monday&#riday effect is not
present in the Hungarian market 04ser1ations re1eal a4normal patterns 4efore the turn of
the millennium ?around !99%@6 4ut this is due to insta4ility of foreign markets )herefore6
the Hungarian market can 4e considered efficient in this sense
)his test <as repeated <ith the e9clusion of outliers 2esults 4olstered the pre1iously
introduced conclusions "here significant days <ere o4ser1ed in the pre1ious testing
stage6 no<6 <ith the e9clusion of the e9treme 1alues6 those days 4ecame e1en more
significant )his <as caused 4y the lo<er standard error Some days that <ere
insignificant6 passed the significance threshold at /N or !0N #urther e1idence that
corro4orates pre1iously attained results is that the signs of the coefficients remained
unchanged in general ;n the fe< cases <here change took place6 1alues <ere close to
Fero #rom this6 <e can deduce that anomalies <ere not caused 4y outliers "ith the
passing of time the anomalies lessened> in the last three years of the study period6 they
<ere undetecta4le )he last three years had less outlier 1alues than in the pre1ious periods
20
)his o4ser1ation again corro4orates the statement that the market 4ecame more efficient 4y
this period
)a4les ! and 2 also sho< the #&statistics of days of the <eeks effect ?A0"@ )he statistic
measures the strength of the regression in e9plaining stock returns )he statistic <as not
significant in any of the tests6 <hich means that stock returns are formed regardless of
<hich day of the <eek it is )XmYri co1ered months of the year in her tests 2esults <ere
analogous to the A0" effect5 it is non&e9istent in the Budapest Stock $9change
2.-.2 Earnings on /ook E0uity
#ama et al ?!99/@ studied the effects of siFe and 4ook&to&market 1alue on earnings )heir
findings pro1ed that earnings are a function of market6 siFe and 4ook e,uity&to&market
e,uity ?B$-M$@ factors High B$-M$ ratios signalled poor earnings and lo< B$-M$ ratios
indicated high returns on capital )his can 4e demonstrated 4y using a simple model that
presumes an all&e,uity firm <hose in1estments are financed internally ?#ama et al !99/ p
!'/@ Ai1idends ?A ?t@@ paid in year t e,ual to e,uity income ?$; ?t@@ plus depreciation ?AP
?t@@ minus in1estments ?; ?t@@ )his is illustrated in the e,uation 4elo<5
@ ? @ ? @ ? @ ? t 1 t DP t 31 t D + =
;n case the e9pected depreciation and in1estments are someho< proportional to the
e9pected e,uity income for any year t=i6 then6
@ ! @? ? @P ? @ ? @ ? Q @ ?
2 !
. . i t 31 3 i t 1 i t DP i t 31 3 i t D 3
t t t
+ + = + + + + = +
<here k
!
and k
2
are the proportionality factors Hi1en r for the discount rate6 <e suppose
for simplicity that r is constant in time )hen6 the present 1alue of the market e,uity at
time t is the follo<ing5

=
+
+
+ =
!
2 !
@ ! ?
@ ?
@ ! ? @ ?
i
i
t
r
i t 31 3
. . t M3
Hence6 the 4ook e,uity and market e,uity ratio <ould 4e5

=
+
+
+ =
!
2 !
@ ! ?
@ ? - @ ?
@ ! ?
@ ?
@ ?
i
i
t
r
t >3 i t 31 3
. .
t >3
t M3
)o interpret the result6 <e take the reciprocal of M$-B$ )he a4o1e formula predicts that
firms <ith higher e9pected earnings ha1e a lo<er B$-M$ ratios )his deduction is also
2!
corro4orated 4y the empirical findings of #ama et al ?!99/@ performed on ( portfolios
composed of stocks of the NGS$6 AM$I and NASAAZ during the years !9('& !992
2.-.# &1E Effect
Studies ha1e sho<n that the price earnings ratio of a firm has predicting po<er o1er the
ne9t period8s returns Basu ?!9++@ tested the claim that lo< P-$ ratio firms tend to
outperform those <ith a high P-$ ratio His research included o1er !.00 industrial firms
that <ere traded on the NGS$ 4et<een Septem4er !9/( and August !9+! He computed
the P-$ ratio for each stock 4y taking the market capitalisation as the numerator6 and the
denominator <as the reported annual earning 4efore e9traordinary items He formed
portfolios of lo< and high P-$ ratios and o4ser1ed their performance Auring the 2/ years6
the portfolios <ith lo< P-$ ratios earned higher returns than the high P-$ securities After
ad=usting for risk6 results did not change Basu further interprets the results as not an
upfront failure of the efficient market hypothesis 2ather6 he e9plains that P-$ ratio
information <as not fully reflected in security prices in as rapid a manner as demanded 4y
the semi&efficient form of $MH )hese lags and frictions are part of market mechanisms
;ndeed the P-$ anomaly did e9ist in the period studied6 ho<e1er6 transaction costs and
ta9es greatly hindered in1estors from yielding a4normal profits $9planations to this
anomaly highlight the e9aggerated e9pectations of in1estors
2.-.' !all"Fir Effect
2elating to the Lanuary effect that <as pre1iously introduced6 the small&firm effect seemed
to accompany the Lanuary returns BanF ?!9%!@ has done research in this field His study
on the common stocks of the NGS$ aimed at finding empirical relationship 4et<een the
return and the total market 1alue 2esults sho<ed that smaller firms possessed higher risk
ad=usted returns6 on a1erage6 than larger firms )his siFe effect has e9isted from the !9.0s
for a4out .0 years ;t is still unclear <hether siFe as such is responsi4le for the effect or
<hether siFe is =ust a pro9y for one or more true unkno<n factors correlated <ith siFe
22
2.-.* 2(er and 3nder +eaction to Earnings
Amongst other anomalies o4ser1ed is share price o1er and under reaction to earnings ne<s
AeBondt and )haler <rote on the issue in their pu4lication in !9%/ B2esearch in
e9perimental psychology suggests that6 in 1iolation of BayesT rule6 most people tend to
[o1erreact[ to une9pected and dramatic ne<s e1entsD ?AeBondt M )haler !9%/ p %0.@
)hey researched data of the NGS$ for the years !92(&!9%2 in an attempt to o4ser1e the
o1er-under reaction hypothesis )heir first hypothesis postulated that e9treme mo1ements
<ere follo<ed 4y a reaction in an opposite direction re1erting it to<ards the mean )his
occurrence is called mean re1ersion )heir other hypothesis assumed that the more
e9treme the mo1ement <as6 the stronger the mean re1ersion AeBondt and )haler
classified stocks into t<o portfolios depending on their performance in the last '( months
prior to the initial point of the testing )his <ay the "inners and the 7osers8 portfolios
<ere created *omparing the performance of the t<o portfolios the authors found that the
7osers outperformed the market 4y !9(N6 the "inners accordingly6 underperformed the
market 4y /N6 despite that the later group included riskier stocks )he results clearly a4ide
4y the o1erreaction hypothesis )he de1iation of the t<o portfolios is asymmetric> the
7osers de1iate more up<ard than the "inners do<n<ard )he difference 4et<een the t<o
portfolios <as siFea4le in the 2
nd
and '
rd
years
)he concept of market 4etas arises "hen taken into account6 the different 4etas in the
portfolios did not contradict the results6 contrarily6 they confirmed them )he pre1ious
"inners had large 4etas on a1erage> there4y the pre1ious 7osers yielded higher returns
<hile 4eing less risky Moreo1er6 a clear Lanuary effect is detected in pre1ious 7osers8
portfolios )his effect is coupled <ith a loss in No1em4ers and Aecem4ers )his
seasonality is faint in the case of pre1ious "inners and e1en contrary in direction A
num4er of aspects of the results remain <ithout satisfactory 1indication> principally6 the
large positi1e e9cess returns earned 4y the loser portfolio e1ery Lanuary Surprisingly6 the
effect lasts as late as fi1e years post portfolio formation
2'
2.-.- Mean +e(ersion
;n AeBondt and )haler the hypothesis of in1estor o1er and reaction is related to the
concept of mean re1ersion ;t is a tendency of stochastic process to remain near6 or 1eer
to<ards a long&run a1erage 1alue According to riskglossarycom6 interest rates and
implied 1olatilities tend to e9hi4it mean re1ersion6 so do stock market returns #igure 2
illustrates the difference 4et<een mean re1erting and non&mean re1erting 4eha1iour
?Source5 riskglossarycom do<nloaded /
th
March6 200%@
#igure 2 Mean re1erting and non&mean re1erting 4eha1iour
)he mean re1ersion model may 4e e9ploited to make e9tra gains ;n general terms6 the
idea is that high or lo< periods in the stock market are only temporary #irst6 <e identify a
trading range for an instrument6 and then compute the mean Sophisticated calculations
relate to assets and earnings of the firm "hen the spot price in the stock e9change goes
4elo< the a1erage price6 the stock 4ecomes attracti1e for in1estors <ho rush to place
purchasing push to raise its price "hen they o1er&react6 the high priced stock is e9pected
to fall $1entually6 prices <ill con1erge to the mean in the long&run Ho< long is the
long&runV )hat is an issue open for argument
#oster and Stine ?200'@ studied the incremental added&1alue of mean&re1erting trading
strategies )hey introduce a test to determine <hether a particular in1estment strategy can
yield profits superseding returns of a 4uy&and&hold in1estment in the SMP inde9 )hey
regress e9cess returns of the selected strategy against the e9cess returns from the 4uy&and&
2.
hold in1estment in the SMP inde9 )he o4tained t&statistic as <ell as the p&1alue of the
intercept indicates <hether adding a ne< strategy leads to a significant impro1ement in the
performance of the portfolio )hey ad=ust the p&1alues using the Bonferonni
/
corrections
for multiple comparisons ;f the regression intercept <ere statistically significant6 then that
means that the particular strategy did add 1alue to the original strategy of 4uy&and&hold the
SMP inde9 )he concept 4ehind this test is that a strategy that gi1es a positi1e mean return
and is not too highly correlated to the 4enchmark inde9 ?SMP in this case@ can 4e linearly
com4ined <ith the inde9 to o4tain a 4etter mean&1ariance return profile Put simply6 any
strategy that pro1es to 4e an ade,uate supplement to di1ersify holdings in the 4enchmark
inde9 can add 1alue
*hua et al ?200.@ e9amined this strategy on their mean&re1erting yield&cur1e strategies
)heir o4=ecti1e <as to test the profita4ility of their strategies that 4uild on the notion that
the yield cur1e mean&re1erts to an unconditional yield cur1e )he results sho<ed that a
num4er of these yield&cur1e trading strategies can yield high profits )his <as especially
true of the trading strategies that focused on mean&re1ersion of the yield spreads and
cur1atures )hese strategies managed to su4stantially outperform t<o commonly used
4enchmarks of in1esting "hen transaction costs <ere included in the model6 profita4ility
of the trades against the 4enchmarks dropped6 yet significant results <ere sustained for
some of these strategies )he authors suggested applying structured deri1ati1e trades that
mirror the underlying cash flo<s in order to reduce the fre,uency of the trades6 thus lo<er
transaction costs considera4ly
2.-.4 The Moentu Effect
#ama and #rench ?!99(@ ha1e also tested t<o 1ersions of momentum strategies AeBondt
and )haler8s ?!9%/@ mean re1ersion anomaly is contradicted 4y #ama and #rench ?!99(@
#ama and #rench tested their ' factor model ?see chapter .'@ and found that portfolios
/
;n his article Her1C A4di e9plains that <hen performing tests on a set of data6 it is more likely to re=ect the
null hypothesis <hen it is true i.e.) a B)ype ;D error )his is due to the logic of the hypothesis testing& <hen
finding rare e1ents6 <e re=ect H0 )he larger the num4er of tests6 the more often <e encounter rare e1ents
)his pro=ects the false 4elief of thinking that there is an effect <hen there is none A4di says that this pro4lem
of inflation of the alpha le1el can 4e a1oided 4y correcting the alpha le1el <hen performing multiple tests
Making the alpha le1el more stringent i.e.) smaller6 <ill create less errors6 4ut it may also make it harder to
detect real effects
2/
formed 4ased on past <inner and losers demonstrated continuation or momentum rather
than the contrarian effect of AeBondt and )haler A pre1ious study 4y Legadeesh and
)itman ?!99'@ corro4orates the concept of momentum )he sample periods they use are
the !9(/:!9%9 period )he strategy they tested6 that picks stocks according to their last (&
month returns and holds them for ( months6 realises a compounded on a1erage e9cess
return of !20!N per year )he authors find further e1idence indicating profita4ility of
their strategies is not due to systematic risk Moreo1er6 test results also indicate that
a4normal profits are not attri4uted to lead&lag effects resultant from delayed stock price
ad=ustments to uni1ersal factors "hen compared to the *APM 4enchmark6 results
confirm the momentum effect as 4eing ,uite large and relia4le
;n their ans<er to the mean re1erting theory6 the authors suggests that Bthe e1idence of
initial positi1e and later negati1e relati1e strength returns suggests that common
interpretations of return re1ersals as e1idence of o1erreaction and return persistence ?ie6
past <inners achie1ing positi1e returns in the future@ as e1idence of underreaction are
pro4a4ly o1erly simplistic A more sophisticated model of in1estor 4eha1iour is needed to
e9plain the o4ser1ed pattern of returns 0ne interpretation of \ QtheirP results is that
transactions 4y in1estors <ho 4uy past <inners and sell past losers mo1e prices a<ay from
their long&run 1alues temporarily and there4y cause prices to o1erreactD ?Legadeesh et al
!99' p 90@ )his interpretation is consistent <ith other studies that e9plored the
implications of the so&called [positi1e feed4ack traders[ on market price
Legadeesh and )itman also look at the ,uestion <hy it is possi4le that the market
underreacts to information a4out the short&term prospects of firms 4ut o1erreacts to
information a4out their long&term prospects )hey 4ring up t<o reasons for B)he nature of
the information a1aila4le a4out a firmTs short&term prospects6 such as earnings forecasts6 is
different from the nature of the more am4iguous information that is used 4y in1estors to
assess a firmTs longer&term prospects )he e1idence in this paper does not allo< us to
distinguish 4et<een these t<o hypotheses a4out in1estor 4eha1iourD ?Legadeesh et al
!99' p 90@
2(
2.-.5 2ther %noalies
0ther anomalies include the follo<ing
5tandard ? Poor8s 1nde4 3ffect
#inancial literature refers to the Standard M Poor8s inde9 effect as 4eing o4ser1a4le as
soon as a company8s inclusion in the inde9 is announced )he perception <as induced 4y
the increased demand from inde9 fund partakers for the stocks in1ol1ed in inde9
composition changes Kappou6 Brooks and "ard ?200+@ studied the SMP /00 inclusions
and e9amined the impact of potential o1ernight price ad=ustments after the announcement
of an SMP /00 inde9 change )he authors found e1idence of Ba significant o1ernight price
change that diminishQedP the profits a1aila4le to speculators although there \ Q<ereP still
profits a1aila4le from the first day after announcement until a fe< days after the actual
e1entD ?Kappou et al 200+ p 2!@
1nitial P+"lic @fferings
)he ;P0 effect <as studied as it appeared to cause an anomaly Knopf and )eall studied
the ;P0 underpricing anomaly in an attempt to e9plain returns of the initial trading day
)hey found e1idence in support of the asymmetric information theories of ;P0
underpricing "hen the in1estor 4ought the listed shares in the last period of the offering
day6 he <ould realise 4elo< a1erage returns on the long&run )his effect <as present e1en
<hen companies <ere segmented according to industry or according to capitalisation )he
underperformance <as compared to se1eral 4enchmark inde9es )he reasons are that on
the day of the offering prices =ump6 and 4uying at the closing price <ill yield <orse than
other in1estment opportunities )he companies that enlist to the stock e9change are
usually o1er&1alued6 4ecause it is not <orth offering under&1alued shares Moreo1er6 it is
not uncommon to <indo<&dress financial statements of companies prior to 4eing listed for
an ;P0 #or instance6 they defer certain costs in order to impro1e their net profit and report
more fa1oura4le results #urther e9planation refers to the loss of efficiency <hen a
company8s di1ision loosens control o1er its achie1ement
2+
Closed9end f+nds
A closed&end fund is a financial instrument that is listed on a certain day6 at a certain
,uantity6 and then initial offering takes place in a secondary market typically from a
4roker )he 1alue of the in1estments in the fund6 and the premium ?or discount@ placed on
it 4y the market are <hat determine the price of a share in a closed&end fund )he total
1alue of all the securities in the fund is di1ided 4y the num4er of shares in the fund )his
is called the net asset 1alue ?NA3@ )he market price of a fund share is fre,uently higher
or lo<er than the NA3 "hen the fundTs share price is higher than NA3 it is selling at a
premium> con1ersely <hen it is lo<er6 it is selling at a discount to the NA3
*losed&end fund shares6 in contrast to open&end funds6 are priced 4y the market6 often
su4stantially di1erging from the NA3 of the fund assets 0pen&end funds are only
a1aila4le for 4uying and selling at the close of 4usiness each day6 at the calculated NA36
and for <hich orders must 4e placed in ad1ance6 4efore the NA3 is kno<n
)he market prices of closed&end funds are often ten to t<enty percent different than the
NA3 <hile the 1alue of an e9change traded fund <ould only 1ery rarely differ from the
NA3 4y more than one&fifth of a percent Malkiel ?!9++@ says that this is in startling
contrast to securities8 market efficiency He de1elops some theoretical principles
concerning the 1aluation of shares of closed&end in1estment companies His conclusion is
that <hile the structure of discounts can 4e partially e9plained on the 4asis of theoretical
principles6 the siFes of the discounts are far larger than <arranted )he years he tested
from !9+0 to !990 demonstrated an a1erage discount ranging from /N to 20N Malkiel
made se1eral conclusions as to <hat =ustifies these premiums and discounts BAiscounts
<ere related to unrealiFed appreciation ?during the period <hen funds had unrealiFed
appreciation@ and to distri4ution policy <ith respect to capital gains6 as <ell as to portfolio
policies concerning in1esting in letter stock and foreign securitiesD ?Malkiel !9++ p%/+@
Ho<e1er6 the general e9planation he gi1es is a psychological one5 generally6 closed&end
companies sell at discounts 4ecause they must 4e 4ought through 4rokers& 4rokers <ho are
not enthusiastic to sell them )he pro4lem stems from in1estor ha4its <hereas in1estment
funds are not all that popular ;t is unlikely to occur to the mind of the a1erage in1estor to
2%
"+y such a fund 2ather6 the pu4lic is sold fund shares 4y the 4rokers or salesmen
Brokers prefer to sell those types of securities that earn them the largest amount of
commission *losed&end funds include <ay less commission than other financial products
Moreo1er6 it is 1ery likely for such a sale to 4e a one&time deal as the in1estors are e1en
less likely to trade closed&end as they do <ith ordinary shares Malkiels on the other hand
e9plains6 that this is still not =ustifia4le reason for the closed&end funds to 4e discounted to
this e9tent6 and there4y the current mispricing should pro1ide indi1idual in1estors great
opportunities ;t seems likely6 that the pricing of closed&end in1estment&company shares
does illustrate an e9ample of a market imperfection in the 1aluation of capital assets
'eather
)he <eather anomaly is not related to <eather deri1ati1es6 contrarily6 it is concerned <ith
the direct relationship 4et<een in1estment am4iance and meteorological factors )he
empirical in1estigation of Saunders in !99' re1ealed the effect of <eather on human
?in1estor@ 4eha1iour He tested the null hypothesis that stock prices from e9changes in
Ne< Gork *ity ha1e not 4een systematically affected 4y local <eather Saunders sho<ed
that there is a negati1e connection 4et<een the cloudy appearance and the yield of stock
markets His conclusion <as that Bthe disco1ery that the <eather in Ne< Gork *ity has a
long history of significant correlation <ith ma=or stock inde9es supports the 1ie< that
in1estor psychology influences stock prices )he causal linkage in these correlations is
strongly supported 4oth 4y the e9tensi1e e9perimental and sur1ey literature indicating that
<eather influences moodD ?Saunders !99' p!'..@ )he esta4lishment of causal direction
4et<een a temporal6 economically insignificant6 local6 mood influence and asset prices
e9plains some of the surprisingly large economic impact this anomaly instigates )he
empirical findings of Saunders support arguments for Bthe inclusion of economically
neutral 4eha1ioural 1aria4les in models of asset&pricing and cast dou4t on the hypothesis
that security markets are entirely rationalD ?Saunders !99' p!'./@
29
2.4 Causes of the %noalies
)he o4ser1ed anomalies induced the search for causes that <ould e9plain the 4eha1iour of
asset mispricing )he most common reason 4rought up for e9plaining the year&end effect
<as ta9&loss selling )his <as rele1ant to countries <ere income from trading is not
e9empt from ta9ation ;n1estors <ith losing positions at the end of the year <ould close
their positions to realise their losses 4efore the ta9 year6 thus sa1e on their paya4le ta9 At
the turn of the calendar year6 they <ould 4uy 4ack the relati1ely cheap assets and reopen
their positions 0nce this <as done 4y a considera4le num4er of in1estors6 the selling
po<er at the end of Aecem4er caused prices to fall e1en more6 and the purchase rally in the
first days of Lanuary accounted for the e9tra profits
"indo<&dressing is the result of the rush of fund managers to appear the performance of
their portfolios in their 4est shape 4efore pu4lishing their reports )heir end of year
premium and their managers8 satisfaction depends on the performance of the funds )his
pro1okes the face&painting of portfolios )he easiest <ay is to sell distressed stocks and
4uy in BstarD instruments regardless of <hich industry they are in ;n the reports6 in1estors
<ill 4e sho<n the Bgood choiceD of portfolio composition the fund manager has made
Another e9planation related to this point is the une1en distri4ution of information )raders
can 4uild on information re1ealed 4y firms6 and only then6 they are a4le make decisions as
opposed to those in connection <ith such information
)his is <hat is called trading against insiders Because it is riskier6 it commands a risk
premium )his idea means that insiders sell in Aecem4er and 4uy 4ack in Lanuary>
in1estors <ho ha1e no insider kno<ledge take up opposite positions )hus6 the Lanuary
effect culminates in higher re<ards
#inally6 in this conte9t it is imperati1e to mention the =oint hypothesis pro4lem )he =oint
hypothesis denotes that the market efficiency hypothesis is coupled <ith the model of
market e,uili4rium <hich is the price setting mechanism )he notion of market efficiency
cannot 4e re=ected <ithout an accompanying re=ection of the model of market e,uili4rium
and this caused much discontent amongst researchers
'0
)he reason for re=ecting the hypothesis stems from the cost of information6 and this makes
the efficient market hypothesis impossi4le to e9ist in reality Prices cannot perfectly
reflect the information <hich is a1aila4le6 since if they did6 those <ho spent resources to
o4tain it <ould recei1e no compensation6 leading to the conclusion that an informational
efficiency of markets is impossi4le 0n the other hand6 the degree of market inefficiency
tempts in1estors to gather and analyse information6 hence non&degenerate market
e,uili4rium <ill arise only <hen there are sufficient profit opportunities6 in other <ords
re<ards to compensate in1estors for the costs of trading and information&gathering B)he
profits earned 4y these industrious in1estors may 4e 1ie<ed as economic rents that accrue
to those <illing to engage in such acti1ities[ 7o and MacKinlay ?!999@6 pages /&(
'!
B'hen yo+ e4pect things to happen 9 strangely eno+gh 9 they do happen./
LP Morgan
# /eha(ioural Finance
LP Morgan <as referring to a phenomenon called self&fulfilling prophecy that can 4e 4est
e9plained 4y 4eha1ioural finance "hat cannot 4e e9plained 4y theory is attri4uted to the
uni,ue psychology of the in1estors #inancial theory presumes rational 4eha1iour from
market participants Get some decisions are made ,uickly6 <ith no sufficient time or
information ;n1estors are also dri1en 4y their desires6 emotions and fears )his is <hat
led to the emergence of 4eha1ioural finance ?B#@ Some of the e9planations B# gi1es to
the nature of price mo1ements include the follo<ing5
Ham4ler8s #allacy5 ;n1estors are inclined to e9pect re1ersal to occur more fre,uently than
they actually do People <ho ha1e poor understanding of the nature of the random
processes tend to fall for the gam4ler8s fallacy
Selecti1e thinking is <hen in1estors 4elie1e <hat they <ant to 4elie1e and take notice of
market signs that are fa1oura4le to them6 ignoring undesira4le e1idence in order to e9plain
a certain trade strategy or a 4elief
)he <eekend effect or the Monday effect is 4ased on the o4ser1ation that share prices tend
to start off on a Monday morning <here they left off on #riday6 thus not taking into
account the money&1alue of the 2 days of the <eekend )his anomaly connotes that #riday
returns ha1e pro1en to e9ceed those of Monday
"indo< dressing is a last minute make&up that portfolio managers gi1e to their assets
4efore the ,uarterly or year&end reports )hey sell off losing instruments or e1ent 4uy into
BhotD sector despite the fund 4eing specialised in something else and in1estor are mislead
to the real holdings of the portfolio )he aim here is to produce desira4le funds in the
reports
'2
#inally6 the hindsight 4ias is an e1er truthful phenomenon ;t gi1es a more predicta4le
1ie< of upcoming e1ents than they really are Kno<ing the outcome of e1ents encourages
o1erconfidence in in1estors
Proponents of 4eha1ioural economics note that financial models often fail to predict
outcomes of the real <orld Beha1ioural insights try to correctly predict some outcomes in
cases <here traditional models failed
' %noalies) &reiu or Inefficiency
Market mechanisms of reacting to ne< information are <hat determine the informational
efficiency of that particular market )he promptness of share prices in reflecting additional
information 4efore it is e9ploited 4y ar4itrageurs is <hat makes a market efficient 2ather6
this process ought to 4e instantaneous ;f not so6 this deficiency <ill lead to mispriced
shares that are a source of a4normal profits
)he degree of efficiency descri4es the e9tent of information prices reflect )aking the
thought of market efficiency a step further6 the only <ay for a market to 4e completely
efficient is 4y allo<ing time for in1estors to react to ne< kno<ledge6 thus ne< transactions
<ill shift prices accordingly )his mechanism <ill6 in turn6 ensure sustaining market
efficiency Get there are al<ays Eearly&4irds8 <hose trading initiates price correction6 and
they are the ones <ho <ill make e9tra profits
Aoes this mean that it is ine1ita4le for market mo1ers to make a4normal ?risk&ad=usted@
profits6 as the market functions this <ayV )his premium is the payment for the so&called
Eearly&4irds8 for researching and looking out for such opportunities
Ho< can data&mining 4e this re<arding <hen market transparency and speed of
information is facilitated 4y modern telecommunicationV ;n reality6 these a4normal profits
e9ceed any =ustified premium Here 7akonishok6 Shleifer and 3ishney ?200.@ maintain
that this is e1idence for market inefficiencies and analysts tend to rely far more on past
''
performance in forecasting the future He says that future performances of gaining shares
tend to 4e assessed more positi1ely than of those shares that are losing on the market )his
is called long memory in the time series
#ama
(
defends the efficient market theory and re4ukes that <hile $MH lacks a sound
alternati1e theory6 a replacing supposition <ould include e9planations of long&term market
o1er&reaction and under&reaction to e1ents as e9planations to the causes of market
anomalies 0n the other hand6 #ama argues that chances of o1er&reaction are a4out as
likely to occur as chances of under&reaction> this is6 in turn6 consistent <ith efficient market
hypothesis
'.1 % Test to the C%&M
)he *apital Asset Pricing Model supposes that all a1aila4le in1estment is represented 4y a
market portfolio that mainly includes stocks )his is in itself a limitation in the *APM as
it is nearly impossi4le to accrue all a1aila4le market in1estments into an inde9 Moreo1er6
the market inde9 defined in theory actually is far from any representation of the real
market inde9 But for the sake of simplification6 <e shall consider the market inde96 the
BUI as the reference in1estment portfolio )he model states that an asset8s return is <orth
as much as the risk free ?r
f
@ in1estment8s pro=ected returns are6 plus 4eta ?

@ times the
market risk premium ? f *
r r
@
@ ?
f * f i
r r r r + =
)he market risk premium is the e9tra return an in1estor can e9pect o1er the riskless 4onds6
in e9change for 4earing risk )his is market risk that is a di1ersified portfolio8s pro4a4ility
of 4ad performance or default )he market does not re<ard systemic risk6 as it can 4e
di1ersified a<ay
;n a ,uarter of a century that <itnessed the *APM8s success6 empirical e1idence 4olstered
the model Haining shares all had high 4etas6 <hich meant that they mo1ed <ith the
market6 and lo< 4eta shares6 accordingly <ere the <orst performing shares Moreo1er6
(
#ama6 $5 Market $fficiency6 7ong&)erm 2eturns6 and Beha1ioral #inance> < (in 3con ?!99%@5 p 2%'&'0(
'.
in1estments made in highly 1olatile instruments <ould make one e9pect high yields $1en
such strategies turned out to 4e re<arding only <hen the 4etas of the underlying
instruments <ere high
*ochrane ?!999@ e9amined !0 portfolios of shares traded on the NGS$ that <ere sorted 4y
siFe according to market capitalisation )here <as an e9tra portfolio for corporate 4onds
and another for long&term go1ernment 4onds He found there to 4e a difference in their
e9cess returns $9cess returns refer to returns 4eyond the risk&free 4onds 7arge shares
had lo<er a1erage returns and smaller shares had higher a1erage returns He also noticed a
large spread 4et<een treasury 4ills and share portfolios )he portfolio a1erage returns
<ere plotted against their 4etas6 and the relationship <ould nicely fall on the *APM
generated regression 0ne portfolio6 ho<e1er6 sho<ed a higher return than the model
<ould predict And this <as the portfolio encompassing the small firms )he de1iation
4eing statistically significant re,uired an e9planation Small firms are riskier> they are
e9pected to yield higher returns6 4ut <hat a4out the e9cess returns not e9plained 4y the
*APM )his <as the much talked a4out Bsmall&firm effectD that <as introduced
;n figure '6 the a1erage returns 1ersus 4etas on the NGS$ 1alue&<eighted portfolio for ten
siFe&sorted stock portfolios6 a portfolio of go1ernment 4onds6 and another for corporate
4onds )he sample period <as !9.+:9( )he 4lack line dra<s the *APM prediction 4y
fitting the market pro9y and )reasury 4ill rates and the coloured line dra<s the *APM
prediction 4y fitting an 07S cross&sectional regression to the displayed data points )he
small&firm portfolios are at the top right Mo1ing do<n and to the left6 one sees
increasingly large&firm portfolios and the market inde9 )he points far do<n and to the
left are the go1ernment 4ond and )reasury 4ill returns ?Source5 *ochrane !999 p'9@
'/
#igure '5 *APM mean e9cess returns plotted against 4eta
'.2 Multiple Factors
"ith hindsight6 it is hard to e9plain the success of the *APM for so long ;t painfully
lacked so many aspects of the real market6 that its simple approach <as marginalised from
the outset Since the times of Merton in the early !9+0s6 asset pricing theorists 1isioned
the need of factors6 or sources of price risk 4eyond the performance of the market
portfolio )he *APM uses a time&series regression to measure 4eta6 <hich ,uantifies a
portfolio8s tendency to mo1e <ith the market as a <hole Multifactor models e9tend this
theory )hey use a time&series multiple regression to ,uantify an asset8s tendency to mo1e
<ith multiple risk factors #
A
6 #
B
6 etc
An important handicap of the traditional *APM model is that it assumes that in1estors li1e
only off their in1estments6 <hich constitutes that they are not affected directly 4y =o4
market recessions )his is not the case in the real <orld )he a1erage in1estor does ha1e a
=o4 #or most of the players on the market6 their aggregate monthly or yearly income is a
sum of their <ealth and their earnings ;mportant e1ents like recessions hit the =o4 markets
and those <ho do not lose their =o4s earn less and <itness a shortfall in their 4onuses #e<
people make money during recessions "ith this in mind6 ; 4ring in the e9ample of t<o
stocks A and B Both ha1e the same sensiti1ity to market mo1ements6 ie they ha1e the
'(
same 4etas But B does <ell during recessions <hile the other does not *leary6 B <ill 4e
preferred 4y in1estors as it <ill compensate their losses on their other income during 4ad
times ;f most in1estors think the same <ay6 they 4id up the price of B6 or they <ill 4e
<illing to hold it at a lo<er a1erage return ;n the same manner6 the instrument A that does
<orse during recessions <ill 4e sold cheaper or it must offer a higher a1erage return for
in1estors <ho are <illing to hold it "e conclude that pro&cyclical instruments that
perform <ell in 4ooms 4ut defect in 4usts <ill ha1e to offer higher returns that the counter&
cyclical instruments6 regardless of their market 4eta )herefore6 another dimension of risk
co&1ariation <ith recession periods <ill 4ecome a factor in asset pricing
Added to this6 <e can 4ring up other inputs of the asset pricing formula that strongly
correlate <ith the returns of in1estment portfolios ;n 4road terms6 in1estors are <illing to
re<ard assets that outperform others especially during 4ad periods )his is particularly
true as recessions are the times <hen <e most need our in1estments to perform <ell to
compensate other losses incurred )his in1ol1es in1estor preference to sacrifice part of
their e9pected returns in e9change for assets that do <ell in recessions )his simple
analysis sheds light on the second factor in the asset pricing factor model *onsumption or
marginal utility is an apt pro9y for measuring recessions )he population reduces its
consumption <hen their income diminishes or <hen the pro=ected future returns on their
in1estments lessen 7o< consumption thus indicates 4ad times <hen in1estors most likely
<ant their in1estments to perform <ell and <ould 4e <illing to pay for that compensation
2egretta4ly6 relating asset returns to consumption data is a part of finance yet to 4e
researched in greater depth None the less6 ; find consumption to 4e a good logical
indicator of <hat factors <e should 4e looking for
$mpirical e1idence e9amined more direct factors relating to asset returns By and large
these include the *APM At its core6 the capital asset pricing model measures the
sensiti1ity of the asset return to the market portfolio8s returns ;n1estors are discontent if
the market is in a do<nfall ;n addition6 factors that influence in1estors8 non&capital gains6
mainly salaries6 are also important )he slope of the yield cur1e of stock or 4ond returns is
a determining factor as <ell )hese factors relate to a1erage consumption #or instance6 if
'+
the market as a <hole declines6 consumers lose money and <ill cut 4ack on their
consumption 2ecessions <itness the loss of =o4s6 and again a decline in consumption
;nterest rate ne<s act similarly as people <ho sa1e e1erything for retirement <ill o4ser1e a
drop in their <ealth )his is <hat connects the predicta4ility of returns and the presence of
additional risk factors for understanding the cross&section of a1erage returns
An additional factor can 4e a factor&mimicking portfolio Sometimes6 <hen our factors are
Euno4ser1a4le8 <e can construct a portfolio <ith the same features using enough securities
)he ne< portfolio is sensiti1ity only to mo1ements of that particular factor it <ishes to
mimic
;t is imperati1e that the risk factors that <e <ish to use to e9plain the mo1ement of future
returns affect the a1erage in1estor $n1isage the case of an e1ent that <ould make in1estor
A 4etter off6 <hile making in1estor B <orse off ;n this case6 A <ill 4uy the instrument
that is affected 4y the e1ent ?or factor@ and B <ill sell it )hus6 they <ill shift the risk of
the factor <hile the price or e9pected return of the instrument <ill remain unchanged #or
a factor to influence prices or e9pected returns6 it must affect the a1erage in1estor6 so
in1estors collecti1ely 4id up or do<n the price and the e9pected return of assets that co1ary
<ith the e1ent rather than =ust transferring the risk <ithout affecting e,uili4rium prices
;nspired 4y this 4road direction6 empirical researchers ha1e found ,uite a num4er of
specific factors that seem to e9plain the 1ariation in a1erage returns across assets )<o
important e9amples of such factors are siFe and 4ook&to&market 1alue ratio
'.2.1 Market Capitalisation and the 6alue &reiu
SiFe and 4ook&to&market 1alue ratio are market factors that under<ent thorough empirical
testing SiFe is determined 4y the market capitalisation of the company ?price times shares
outstanding@ 3alue <as measured 4y the 4ook 1alue to market 1alue ratio "hen the
4ook e,uity to market e,uity ratio ?B$-M$@ is high6 the stocks of the company are referred
to as (alue stocks *on1ersely6 lo< 4ook e,uity to market e,uity identifies gro,th
stocks. )he logic 4ehind this is that higher returns are compensation for higher systematic
risk #ama and #rench suggest that 4ook&to&market and siFe are Bpro9ies for distress and
'%
that distressed firms may 4e more sensiti1e to certain 4usiness cycle factors6 like changes
in credit conditions6 than firms that are financially less 1ulnera4leD ?#ama and #rench
!99( p /%@
Possi4le e9planations for the high discount rate assigned to small capitalisation and high
B$-M$ firms cause de4ate amongst e9perts )he traditional e9planation for these
o4ser1ations ad1ocated 4y #ama and #rench ?!99'6 !99(@ is that the higher returns are
compensation for higher systematic risk #ama and #rench ?!99'@ e9plain that B$-M$ and
siFe pro9y distress and that trou4led firms are more suscepti4le to certain 4usiness cycle
factors6 like changes in credit conditions6 than firms that are financially less 1ulnera4le
)his means that in1estors are <illing to gi1e up on some e9pected return in e9change for
in1estments that are resilient to market tur4ulences )his causes the premium in small siFe
and high B$-M$ stocks
7akonishok et al ?!99.@ propose that the high returns associated <ith high B$-M$ stocks
are generated 4y in1estors <ho incorrectly e9trapolate the past earnings gro<th rates of
firms )hey suggest that in1estors are o1erly optimistic a4out firms <hich ha1e done <ell
in the past and are o1erly pessimistic a4out those that ha1e done poorly )he authors also
suggest that gro<th stocks are more glamorous than 1alue stocks and may thus attract
nai1e in1estors <ho push up prices and lo<er the e9pected returns of these securities
3alue stocks ha1e market 1alues that are small relati1e to the 1alue of assets on the
company8s 4ooks Both 1alue stocks as <ell as small capitalisation stocks ha1e high
a1erage returns 7arge and gro<th stocks are the opposite of small and 1alue stocks <hich
seem to ha1e unusually lo< a1erage returns )he idea that lo< prices lead to high a1erage
returns is natural High a1erage returns are consistent <ith the *APM6 if these categories
of stocks ha1e high sensiti1ity to the market6 ie high 4etas Ho<e1er6 small and
especially 1alue stocks appear to ha1e a4normally high returns e1en after accounting for
market 4eta *on1ersely6 gro<th stocks do systematically <orse than their *APM 4etas
suggest *ochrane ?!999@ demonstrates this 1alue&siFe puFFle 4y sorting stocks into
portfolios 4ased on siFe and 4ook&to&market ratio )he highest portfolios ha1e three times
'9
the a1erage e9cess return of the lo<est portfolios6 and this 1ariation has nothing to do <ith
market 4etas
)o understand the real6 macroeconomic6 aggregate6 non&di1ersifia4le risk that is pro9ied 4y
the returns of the high B$-M$ and small capitalisation portfolios6 #ama and #rench ?!99/@
note that the typical 1alue stock has a price that has 4een dri1en do<n due to financial
distress )he stocks of firms on the 1erge of 4ankruptcy ha1e reco1ered more often than
not6 <hich generates the high a1erage returns of this strategy )his o4ser1ation suggests a
natural interpretation of the 1alue premium5 in the e1ent of a credit crunch6 li,uidity
crunch6 or flight to ,uality6 stocks in financial distress <ill do 1ery 4adly6 and this is
precisely <hen in1estors least <ant to hear that their portfolio is losing money
+
'.# Three Factor Model of Faa and French
#ama8s contri4ution is cro<ned 4y his <ork <ith his colleague #rench
%
<ith <hom he
de1ised the three&factor model that e9tends the single market premium factor of traditional
asset pricing theories ;n their <ork6 they sho< that sensiti1ity to siFe and 1alue pro1ides
an ade,uate model for share price mo1ements )he first factor is denoted as SMB ?small
minus 4ig@ <hich is the difference 4et<een the returns on di1ersified portfolios of small
capitalisation stocks and a portfolio of large stocks constructed to 4e neutral <ith respect to
4ook e,uity to market e,uity ?B$-M$@ )he second factor is HM7 ?high minus lo<@ is the
difference 4et<een the returns on di1ersified portfolios of high and lo< 4ook e,uity to
market e,uity shares constructed irrespecti1e to siFe )he 4etas are e1idently slopes in the
regression )heir model is descri4ed in the e,uation 4elo<5
i
t t iHMA t i5MA
f
t
*
t i* i
f
t
i
t
HMA 5M> $ $ $ $ + + + + = @ ?
2
i
is the return on asset i6 2
f
is the risk&free interest rate6 and 2
m
is the return on the 1alue&
<eight market portfolio
+
)he indi1idual risk of firms is not counted as a risk factor as such distress is idiosyncratic and can 4e
eliminated 4y di1ersification6 only aggregate e1ents that a1erage in1estors care a4out can result in a risk
premium
%
#ama6 $> #rench K5 )he *apital Asset Pricing Model5 )heory and $1idence> )he Lournal of $conomic
Perspecti1es6 3ol !%6 No ' ?Summer6 200.@6 pp 2/&.(
.0
)a4le . sho<s the summary statistics of the three factors8 regression on the Luly !929 to
Lune !99+ time&series #ama and #rench split the sample on Luly !9(' to test <hether the
later period is unusual )he t<o su4 periods are e,ual in length6 '. years ?Source5 #ama
and #rench 2000 p (@
)a4le '5 Summary Statistics for Monthly Percent )hree&#actor $9planatory 2eturns
$f is the one&month )reasury 4ill rate from ;44otson Associates $i is the 1alue&<eight
return on all NGS$6 AM$I6 and NASAAZ stocks <ith 4ook e,uity data for the pre1ious
calendar year At the end of Lune of each year t ?!92( to !99(@6 stocks are allocated to t<o
groups ?small or 4ig@ 4ased on their Lune market capitalisation6 M$ ?market e,uity <orked
out 4y stock price times shares outstanding@6 is 4elo< or a4o1e the median for NGS$
stocks Stocks are allocated to three 4ook&to&market e,uity ?B$-M$@ groups ?76 M6 or H@
4ased on 4reakpoints for the 4ottom '0 percent6 middle .0 percent6 and top '0 percent of
the 1alues of B$-M$ for the NGS$ stocks in their sample Si9 portfolios ?S-76 S-M6 S-H6
B-76 B-M6 and B-H@ are formed as the intersections of the t<o siFe and the three B$-M$
groups 3alue&<eight monthly returns on the portfolios are calculated from Luly of year t
to Lune of t=1
)he a1erage 1alue of the market premium ?$
*
9$
f
B for the full (%&year sample period is 0(+
percent per month ?t&statistic S ''.@ <hich is a4out 2. standard errors from Fero )his
strong market premium in returns in not surprising )here is also a relia4le 1alue premium
in returns )he a1erage HM7 return for the full Luly !929 to Lune !99+ is 0.( percent per
month ?t&statistic S .2.@ )he siFe effect ho<e1er is modest in comparison <ith the
pre1ious results )he a1erage SMB return for Luly !929 to Lune !99+ is 020 percent per
month ?t&statistic S !+%@ Perhaps the reason for this is that SMB is neutral <ith respect to
B$-M$ 4ecause small stocks tend to ha1e higher B$-M$ than 4ig stocks6 and a siFe
premium that is not neutral <ith respect to B$-M$ in part reflects the 1alue premium in
returns
.!
'.' Characteristics Model of $aniel and Titan
)he three factor model confirms that firm siFes and 4ook&to&market e,uity ratios are 4oth
highly correlated <ith the a1erage returns of stock market instruments )he #ama and
#rench e9planation of their model associates the siFe and 1alue characteristics <ith returns
)hey e9plain that the characteristics are pro9ies for non&di1ersifia4le factor risk6 and that
the sensiti1ities of underlying stocks <ith the factors ?factor 4etas@ directly influence
returns Aaniel and )itman re4ut this idea ;n their article in !99+6 they pro1ide e1idence
that the return premia on small capitalisation and high 4ook&to&market stocks does not arise
4ecause of factor 4etas )hey 1oice the role of the characteristics rather than the
co1ariance structure of returns that appear to e9plain the cross&sectional 1ariation in stock
returns
A4undant e1idence e9ist that cross&sectional pattern of stock returns can 4e e9plained 4y
characteristics such as siFe6 4ook&to&market ratios6 le1erage6 past returns6 and di1idend&
yield among others #ama and #rench8s e9amination of these 1aria4les simultaneously
concludes that the cross&sectional dispersion in e9pected returns can 4e satisfactorily
e9plained 4y t<o of these characteristics6 namely5 siFe and 4ook&to&market ratio Beta6 the
risk measure in the traditional capital asset pricing model e9plains 1ery little of the cross&
sectional 1ariation in e9pected returns once siFe is taken into account ;n order to
determine e9pected returns6 Aaniel and )itman suggest a model of the B2eturn Henerating
Process #irm characteristicsD ?Aaniel et al !99+@ rather than factor loadings
)heir characteristic&4ased pricing model6 in contrast to the factor pricing model6 assumes
that high 4ook&to&market stocks realise a return premium that is unrelated to the underlying
co1ariance structure As in #ama and #rench8s model6 co1ariances are stationary o1er time
and can 4e descri4ed 4y a factor structure Here6 a time&in1ariant <&factor descri4es the
1ariance&co1ariance matri9 of returns is assumed ?Source Aaniel and )itman !99+ p9@
.2
t i
<
C
t C C i t i t i
f r 3 r
6
!
6 6 6 6
O
O
P
O
Q
O
+ + =

=
@6 6 0 ? O
2
6 ei t i
:

@ ! 6 0 ? O
6
: f
t C
<here C i6

is the loading of firm i on factor C and

t C
f
6
O
is the return on factor C at time t Ho<e1er6
in contrast to the pre1ious models6 factor loadings do not descri4e e9pected returns
;nstead6 it is assumed that e9pected returns are a function of the o4ser1a4le6 slo<ly 1arying
firm attri4ute or characteristic t i6
O

5 ?source Aaniel and )itman !99+ p!0@

! t 6 i ! t 6 i
O
4 a P r
O
Q $

+ =
As in the factor model6 the inno1ations in are negati1ely correlated <ith the returns on
the stock6 4ut is not directly related to the loadings on the distressed factors "hat is
uni,ue a4out the characteristics model is that firms e9ist that load on the distressed factors
4ut <hich are not themsel1es distressed6 and therefore ha1e a lo< and thus lo< returns
and 1ice 1ersa ;f the characteristics model holds6 then a series of negati1e shocks to a
specific factor may 4e follo<ed 4y some stocks that6 despite their high loadings on that
factor6 are still not distressed )he factor model suggests that these firms should still earn
the distress premium6 4ecause they 4eha1e like other distressed firms ;n contrast6 the
characteristics model suggests their returns 4eha1iour does not matter5 if they are not
distressed they <ill not earn the premium )his model implies that a cle1er in1estor can
earn the 4ook&to&market return premium <ithout loading on any common factors
)he regression results for the characteristic&4alanced portfolios of Aaniel and )itman
support these findings )a4le / presents each of the coefficients and t&statistics from the
follo<ing time&series regression of the Fero&in1estment portfolio returns6 descri4ed 4elo<6
on the e9cess&market6 SMB and HM7 portfolio returns5
5M> 5M> HMA HMA M.t M.t f . C i
$ $ $ $ $ + + + =
6 6
)he regressions are o1er the period Luly !9+' to Aecem4er !99' )he left hand side
portfolios are formed 4ased on siFe ?S]@6 4ook&to&market ?BM@6 and pre&formation HM7
factor loadings> their returns are calculated as follo<s #rom the resulting forty&fi1e
returns series6 a Fero&in1estment returns series is generated from each of the nine siFe and
4ook&to&market categories )hese portfolios are formed6 in each category6 4y su4tracting
the sum of the returns on the .
th
and /
th
,uintile factor&loading portfolios from the sum of
the returns on !
st
and 2
nd
factor&loading portfolios )he first nine ro<s of the ta4le present
.'
the t&statistics for the characteristic&4alanced portfolio that has a long position in the lo<
e9pected factor loading portfolios and a short position in the high e9pected factor loading
portfolios that ha1e the same siFe and 4ook&to&market rankings )he 4ottom ro< of the
ta4le pro1ides the coefficient estimates as <ell as the t&statistics for this regression for a
com4ined portfolio that consists of an e,ually&<eighted com4ination of the a4o1e nine
Fero&in1estment portfolios ?)a4le 4elo<5 source Aaniel et al !99+ p!%@
)a4le .5 2egression 2esults for the *haracteristic&Balanced Portfolios
)hese are [characteristic&4alanced[ portfolios6 since 4oth the long and short positions in
the portfolios are constructed to ha1e appro9imately e,ual 4ook&to market ratios and
capitalisations ;n the model6 <here no transaction costs are assumed6 such a portfolio
construction costs nothing initially
)he characteristic&4ased model predicts that the a1erage return from these Fero cost
characteristic&4alanced portfolios should 4e indistinguisha4le from Fero )he results
reported in )a4le / re1eals that all 4ut one of the as from the time&series regressions of the
nine indi1idual characteristic&4alanced portfolio returns on the factor returns are positi1e6
and three of the nine ha1e t&statistics a4o1e t<o <hich is consistent <ith the characteristic&
4ased pricing model 4ut inconsistent <ith the factor pricing models
..
)he latest study on this topic 4y Aaniel and )itman ?200!@ replicated the methodology of
their !99+ tests on the Lapanese market from !9+/ to !99+ )he authors maintain that
Lapanese stock returns are e1en more closely related to their 4ook&to&market ratios than
their US counterparts )he tests re=ect the #ama and #rench three&factor model6 4ut fail to
re=ect the characteristic model )he results6 ho<e1er6 may 4e su4=ect to sample 4ias and
might not 4e applica4le to other markets Aaniel et al ?200!@ conclude that this is a
,uestion that stimulates further research
* Epirical Findings of the /udapest !tock E7change
Historical data <as gathered from portfoliohu and a check <as done to confirm its 1alidity
4y comparing it to data gained from the Budapest Stock $9change <e4site ;n order to
compare the t<o data series6 ; used a macro that highlighted differences in share prices for
the same dates )he portfoliohu data pro1ed to 4e incomplete in se1eral cases> therefore6 ;
relied on the 4ethu <e4site for data do<nload ; <orked <ith 2' shares ?!( of <hich
compose the BUI 4asket@6 distri4uted 1ariously 4et<een A and B category shares all
traded on the Budapest Stock $9change 4et<een Septem4er 200' and Septem4er 200%
Using the 3700KUP function in MS $9cel6 daily closing prices and di1idends <ere
ad=usted according to trading days for each share )he task <as to collect information on
a specific date for all the shares on one ro< ;n this process6 ; o4tained numerous 4lank
cells6 <hich indicated una1aila4le data 7ater ; had trou4le coping <ith missing data
9

*.1.1 Calculating beta and ean return
#or each share6 the daily return <as calculated using the formula5
t T
t
T t t T
i
P
Di P P
r

+
=
<here P
)
is the share price on day )6 the di1idend is the amount paid 4et<een t and )6 and
P
t
is the share price in the period preceding ) ;n my calculations6 ; presumed that
in1estors follo< a 4uy&and&hold strategy for one year6 and then they realise gains or losses
)herefore6 the time elapse 4et<een t and ) is '(/ calendar days )hen the mean6 standard
9
)o handle N-A data6 one method is not to include them in calculations6 or another method is 4y replacing
them <ith the mean ; chose the first option
./
de1iation and 1ariance of these returns <ere gi1en for each share ; also produced daily
returns for the BUI inde9 in the same <ay6 to ser1e my calculations as a market pro9y
$ach share8s daily yields8 co1ariance <ith the market yields <as <orked out )he market
4eta for each share <as o4tained 4y the formula5
2
6
2

@ 6 co1?
*ar.et
* i * i
*ar.et
* i
i*
r r

= =
2esults are summed up 4elo< )a4le !+ highlights the returns on the stocks6 and their
empirical 4etas o4tained using the method e9plained a4o1e6 and <here a1aila4le6 ;
included the 4eta gi1en 4y 2euters for the !( shares that make up the BUI inde9 Here6 ;
used the longest possi4le time&frame that e9tended from Lanuary !99( : No1em4er 200+
0)P 2ichter M07 M&telekom $gis Any Aanu4ius $conet
Stock return 0+/( 0''% 0/2' 0.0+ 022! 0929 029/ &00/0
$mpirical 4eta 0'+! 0/0' 0'%% 0/9/ 0/9. &0009 0(+! 0!%.
2euters 4eta !0/0 0+90 !2!0 0%%0 !!20 0.'0 0+/0

$masF #HB #ote9 Pplast
Phyla9i
a 2a4a
Synergo
n )3K
Stock return 0''+ 0++/ 020% &002( &0!(/ &02'9 &00%. 02/(
$mpirical 4eta 0'2' 0!09 0/+% 0/(. 029% 02%( 0.!+ 0/!%
2euters 4eta 0(.0 0%%0 0%%0 0!.0 0(%0 0'!0 !000
)a4le / 2eturns of the !( BUI constituent stocks6 their 4etas calculated using yearly
yields pro=ected on ! day6 and their 2euters 4eta *alculation period !99( : 200+
.(
Epirical /eta
-0.4
-0.2
0
0.2
0.4
0.6
0.8
1
-0.1 0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8
OTP Richter MOL M-telekom Egis
Any Danubius Econet Emasz FHB
Pannonplast Phylaxia Raba Synergon TVK
#igure .5 $mpirical 4eta for BUI components6 calculation period !99( &200+
+euters /eta
-0.4
-0.2
0
0.2
0.4
0.6
0.8
1
0 0.2 0.4 0.6 0.8 1 1.2 1.4
OTP Richter MOL M-telekom Egis
Danubius Econet Emasz FHB Pannonplast
Phylaxia Raba Synergon
#igure /5 2euters 4eta for BUI components6 calculation period / years
; figure that using !2 years to calculate a 4eta may 4e irrele1ant as the Hungarian capital
market6 as <ell as Hungarian currency <ent through immense changes since !99( )a4le
!% depicts the same results as a4o1e using a shorter time&series from Septem4er 200.&
March 200% highlighting all 2' shares

.+
Aanu4ius $conet $gis #ote9 7inamar M07 M&telekom 0)P
Stock return 09!( 020/ 0'.( 0%(. 0+!% 0+.! 0/+. 0(/'
$mpirical 4eta 02%2 &0!!+ 0'(/ 0'!+ &0!!/ 029+ 0+%% 0%.+
2euters 4eta 0.'0 0+/0 !!20 0%%0 !2!0 0%%0 !0/0

Pannon 2a4a 2ichter
Synergo
n )3K ]<ack *sepel $hep
Stock return 0'.9 0202 02.2 0+/. 0/%/ 099+ 0('. 099(
$mpirical 4eta 029( &0.!! 0!/+ 000% 0/.. 0000 0+/( 0000
2euters 4eta 0'!0 0+90 !000

$lmu $94us #orras-oe Hardenia Humet KonFum Phyla9ia
Stock return 0+'/ &0(2! 09.% 0!2! 022% 0+9/ 00.'
$mpirical 4eta 02/9 0!!/ &002/ 0!/! &0.(9 0.(( 02%0
2euters 4eta 0(%0
)a4le (5 Stock returns6 4etas calculated using yearly yields pro=ected on ! day6 2euters
4eta *alculation period Septem4er 200. : Sept 200%
Using information from the ta4le a4o1e6 figures % and 9 4elo< sho< the 4etas plotted
against mean returns for the 2' shares
Epirical /eta
-0.8
-0.6
-0.4
-0.2
0
0.2
0.4
0.6
0.8
1
1.2
-0.6 -0.4 -0.2 0 0.2 0.4 0.6 0.8 1
Dan Eco Eg Ftx Lin Mol Mcom Otp
Pan Raba Syn Tvk Zw Cs Eh El
Exbus F Gard Hu Konzum Phyl Rg
#igure (5 $mpirical 4eta ?9 a9is@ graphed against stock return ?y a9is@6 period Sept 200. :
Sept 200%
.%
+euters /eta
-0.8
-0.6
-0.4
-0.2
0
0.2
0.4
0.6
0.8
1
1.2
0 0.2 0.4 0.6 0.8 1 1.2 1.4
Dan Eco Eg Ftx Lin Mcom
Otp Pan Raba Syn Tvk Zw
Cs Eh El Exbus F Gard
Hu Konzum Phyl Rg Mol
#igure +5 2euters 4eta ?9 a9is@ graphed against stock return ?y a9is@6 period / years from
200+
;n my model6 ; relied on the regression for o4taining the market 4eta 2eading
Aamodaran6 ; think ; ought to apply other approaches as it is ad1isa4le to use a shorter
period ?eg 2 years@ <hen calculating 4eta *ompany profiles change o1er time and past
co1ariance <ith the market might 4e irrele1ant to the current situation of the company ;
tried to check the so&called 4eta 4ooks6 4ut unfortunately6 Hungarian companies are not
represented <ith a fe< e9ceptions )his is <hy ; included 4eta o4tained from 2euters
*.1.2 Foring &ortfolios
;n order to test the 1alidity of the siFe and 1alue factors in e9plaining returns on e,uity
traded on the Budapest Stock $9change6 the gathered data from Septem4er 200' to March
200% of 2' stocks <as mi9ed 4et<een A and B category stocks )he stocks <ere grouped
into ( portfolios according to siFe and 4ook&to&market e,uity ratio )he small firms ?S@
<ere composed of companies <ith market capitalisation 4elo< the median irrespecti1e of
their 4ook&to&market e,uity ratio6 and the 4ig firms ?B@ <ere those that <ere a4o1e the
median )he high ?H@ 4ook&to&market e,uity ratio firms <ere the top '0
th
percentile of the
shareholder e,uity&to&market capitalisation ratio irrespecti1e of siFe6 the medium ?M@
category constituted the middle .0
th
percentile and the lo< ?7@ the lo<est '0
th
percentile
.9
)o take a look at ho< 1alid this grouping <as ; performed a hierarchical cluster analysis
using the statistical analysis soft<are SPSS6 once according to e,uity capitalisation and the
second time6 according to 4ook&to&market e,uity ratio6 using 4et<een groups linkage and
s,uared $uclidean distance ; also repeated the results using <ithin&groups linkage and
$uclidean distance 2esults are 4est 1isualised using a dendrogram6 this is sho<n in
appendi9 ! ;n reading the dendrogram6 the result is normally taken at a distance 4et<een
!0 and !/ on the dendrogram scale )he formed clusters match <ith the pre1ious grouping
made according to percentiles and median as in #ama and #rench
Portfolios <ere formed at the 4eginning of each financial year6 and regrouped accordingly
e1ery ne9t Lanuary )he shares in the portfolios <ere 1alue&<eighted using their market
capitalisation for <eights6 and categorised )he resultant ( portfolios <ere the follo<ing5
S-H6 S-M6 S-76 B-H6 B-M6 B-7 )his meant that the first S-H portfolio contained shares
that <ere small in siFe and <ith a high B$-M$ Appendi9 2 sho<s the portfolio
constituents for each year
;n *ochrane ?!999@ portfolios of different siFes <ithin the same 4ook-market category
<ere connected #igure !0 sho<s a1erage returns 1ersus market 4eta for 2/ stock
portfolios sorted on the 4asis of siFe and 4ook-market ratio )he points are the same in
4oth panels ;n panel A6 lines connect portfolios as siFe 1aries <ithin 4ook-market
categories> in panel B6 lines connect portfolios as 4ook-market ratio 1aries <ithin siFe
categories 3ariation in siDe produces a 1ariation in a1erage returns that is positi1ely
related to 1ariation in market 4etas6 as sho<n in panel A Panel B connects portfolios that
ha1e different 4ook-market ratios <ithin siFe categories 3ariation in 4ook-market ratio
produces a 1ariation in a1erage return that is negati1ely related to market 4eta Because of
this 1alue effect6 the *APM is a disaster <hen confronted <ith these portfolios ?Source5
*ochrane !999 p .!@
/0
#igure %5 Mean e9cess returns 1s market 4eta6 1arying siFe and 4ook-market ratio
; <ished to check <hether this realisation is 1alid for our 2' Hungarian shares ; took the
shares plotted in figure %6 and in an analogous <ay to *ochrane6 ; connected shares that are
close in B$-M$ to each other irrespecti1e of siFe )he darker line represents firms that
<ere the top '0
th
percentile B$-M$ ratio6 and therefore la4elled as the high firms )he
orange line connects the medium firms <ith the middle .0
th
percentile of B$-M$6 <hilst
the 4right yello< indicate lo< B$-M$ firms <ith the lo<est '0
th
percentile of 4ook&to&
market e,uity ratio )he lighter line sho<s firms <ith market capitalisation a4o1e the
median6 these are the 4ig firms #igure !! clearly sho<s that 1ariation in siDe produces a
1ariation in a1erage returns that is positi1ely related to 1ariation in market 4etas
/!
#igure 95 3arying siFe <ithin 4ook&to&market e,uity ratio groups
;n figure !26 ; connected shares that are close in siFe to each other irrespecti1e of B$-M$
)he darker line represents firms that <ere 4elo< the median market capitalisation6 and
therefore la4elled as the small firms )he lighter line sho<s firms <ith market
capitalisation a4o1e the median6 these are the 4ig firms ;t is clear6 that 1ariation in
4ook-market ratio produces a 1ariation in a1erage return that is negati1ely related to
market 4eta
#igure !05 3arying 4ook&to&market e,uity ratio <ithin siFe groups
/2
)he multifactor model ad1ocated 4y #ama and #rench ?!99'6 !99(@ e9plain these facts
)he factors5 market return6 the return of small less 4ig stocks ?SMB@6 and the return of high
4ook-market less lo< 4ook-market stocks ?HM7@ as three factors sho<6 that 1ariation in
a1erage returns of the siFe and 4ook-market portfolios can 4e e9plained 4y 1arying
loadings ?4etas@ on the latter t<o factors
*.1.# The Factors) Market &reiu. !M/ and HM8
)he market premium is the e9cess return that in1estments yield o1er the risk&free return ;
considered the BUI return as the market return ?r
m
@ <hile the Hungarian ' month
reference rate as the risk&free rate ?r
f
@ of go1ernment 4onds )he pro4lem arises that the
market return does not includes all a1aila4le in1estment opportunities6 and as for the risk&
free return6 the inter&4ank s<ap rates <ould pro1ide a more dynamic indicator of market
e9pectations )he difficulty of ,uantifying the former6 and o4taining a time&series of the
latter6 unfortunately6 confined me to only mentioning them #igure !' 4elo< illustrates the
BUI yearly return and the ' month go1ernment 4ond yield from #e4ruary !99+ to March
200%
-100.00%
-50.00%
0.00%
50.00%
100.00%
150.00%
200.00%
1
7
/
0
2
/
1
9
9
7
1
7
/
0
2
/
1
9
9
8
1
7
/
0
2
/
1
9
9
9
1
7
/
0
2
/
2
0
0
0
1
7
/
0
2
/
2
0
0
1
1
7
/
0
2
/
2
0
0
2
1
7
/
0
2
/
2
0
0
3
1
7
/
0
2
/
2
0
0
4
1
7
/
0
2
/
2
0
0
5
1
7
/
0
2
/
2
0
0
6
1
7
/
0
2
/
2
0
0
7
1
7
/
0
2
/
2
0
0
8
Rbux yearly Rf
#igure !!5 BUI yearly return and the ' month go1ernment 4ond yield from #e4ruary !99+
to March 200%
/'
;t is o4ser1ed that there is a negati1e market premium se1eral times in history as figure !.
sho<s
-0.003
-0.002
-0.001
0
0.001
0.002
0.003
1
7
/
0
2
/
1
9
9
7
1
7
/
0
2
/
1
9
9
8
1
7
/
0
2
/
1
9
9
9
1
7
/
0
2
/
2
0
0
0
1
7
/
0
2
/
2
0
0
1
1
7
/
0
2
/
2
0
0
2
1
7
/
0
2
/
2
0
0
3
1
7
/
0
2
/
2
0
0
4
1
7
/
0
2
/
2
0
0
5
1
7
/
0
2
/
2
0
0
6
1
7
/
0
2
/
2
0
0
7
1
7
/
0
2
/
2
0
0
8
Rm-Rf
#igure !25 Market premium is sho<n 4y the e9cess return o1er the risk free rate
;n my calculations ; used the yearly returns pro=ected on a single day6 using the e,uation5
'(/
yearly
i
daily
i
r r =
Aamodaran 0nline suggests that Hungary use a market premium /99N )his information
<as updated in Lanuary 200%> ho<e1er6 ; <as una4le to find historical market premia for
Hungary )herefore6 ; relied on empirical data
)he SMB and the HM7 factors <ere formed using the formulas of #ama and #rench
?!99(@ p'92
'
@ ?
'
@ ?
H
>
M
>
A
>
H
5
M
5
A
5
5M>
+ +

+ +
=
2
@ ?
2
@ ?
A
>
A
5
H
>
H
5
HMA
+

+
=
/.
)he SMB factor sho<s the premium of the small capitalisation firms o1er the portfolio of
4ig firms )he HM7 descri4es the premium of the high 4ook&to&market e,uity ratio firms
o1er the lo< ratio firms6 in other <ords 1alue less gro<th stocks
;n #ama and #rench ?!99(@ the correlation 4et<een SMB and HM7 for the Luly !929 to
Lune !99+ period <as 0!' #or the Hungarian market for the period 200.&200% the
correlation is &02%% as sho<n in ta4le !9 )hus6 SMB indeed seems to pro1ide a measure
of the siFe premium that is some<hat free of B$-M$ effects6 and HM7 is a measure of the
B$-M$ premium relati1ely free of siFe effects
HML SMB
HML 1.000000 -0.288366
SMB -0.288366 1.000000
)a4le +5 *orrelation matri9 of the factors HM7 and SMB
; tested the HM7 and SMB factor for Hranger causality ;n the first case <e cannot re=ect
the hypothesis that SMB does not Hranger cause HM7 at a /N significance le1el6 4ut <e
do re=ect the hypothesis that HM7 does not Hranger cause SMB )herefore it appears that
Hranger causality runs one&<ay from HM7 to SMB and not the other <ay )a4le 20
summarises the results
a!r"!#e $ra%&er 'au#al!(y )e#(#
Sam*le+ 9/20/2004 3/31/2008
La&#+ 5
,ull Hy*-(.e#!#+ /b# 0-S(a(!#(!1 r-bab!l!(y
SMB 2-e# %-( $ra%&er 'au#e HML 874 2.01188 0.07471
HML 2-e# %-( $ra%&er 'au#e SMB 2.60463 0.02387
)a4le %5 Hranger causality test for the factors HM7 and SMB
*.1.' Faa9s odel tested on the /udapest !tock E7change
#ama and #rench in their paper pu4lished in !99/ plotted the 4etas of share portfolios
against their mean e9cess return )hey propose a three&1aria4le model to e9plain the
mo1ement of prices )heir reno<ned formula <as ?source #ama and #rench !99( p //@5
//
+ + + + = dHMA c5M> $ $ " a $ $
f * f i
@ ?
)heir regression fitted nota4ly <ell )his induced se1eral retests 4y other researchers
including *ochrane ?Ne< #acts in #inance@ <ho argues that the HM7 factor is not a solid
e9planation of the e9cess return of stocks ?r
i
&r
f
@ as high B$-M$ indicates companies in
distress And it is more common for the distresses companies to 4ounce 4ack than to
default )his premium is therefore the price of sur1i1al #ama and #rench re1ise their
<ork in !99( and comment the HM7 factor saying that Ba su4stantial part of the premium
is due to sur1i1or 4ias> the data source for 4ook e,uity \ contains a disproportionate
num4er of high&B$-M$ firms that sur1i1e distress6 so the a1erage return for high&B$-M$
firms is o1erstatedD ?#ama and #rench !99( p/+@
#or the Budapest Stock $9change8s 2' firms6 a summary ta4le of the regressions of the
three factors and a constant ?*@5 ?HM76 SMB and 2mW2f@ are sho<n in ta4le 2! "here
the factors are significant on a /N significance le1el6 they are sho<n in 4old letters ;t is
clear from the ta4le that the siFe6 the 1alue and market premium factors <ork <ell for the
period e9amined 0n a1erage6 the SMB factor 4eta is 060( the HM7 0602 <hile the market
factor has a 4eta of 0629 )his is interpreted as !N point change in returns can 4e e9plained
4y 4eta times the gi1en factor
/(
6ariable
Coefficien
t !td. Error t"!tatistic &rob. +"s0uared
Csepel C 0/%9+++ 00%'+/( +0.!/%9 00000 02+%%.!
HM7 &0!!2.0. 0!.+!9 &0+('(+ 0..(+
!M/ 0.+0.%( 0!!('+9 .0.2+09 0000!
+M:+F 0/%0'(. 009(!%! (0'.!02 00000
Dan+"i+s C 09+9//+ 00!'9(! +0!(22' 00000 0!(9.0/
HM8 0!!+'(! 002/!'9 .((%./. 00000
SMB 00!%0'9 00!+0%( !0//+99 029!.
+M:+F 02+'.2/ 002.+(! !!0.2(. 00000
3conet C 0..0.'% 0029/'9 !.9!0.9 00000 0.0.0'/
HM8 0+/'!2( 00/.'%/ !'%.%09 00000
!M/ 0+9!09! 00'/!+9 22.%++2 00000
+M:+F 0'0!!0/ 00/(%/9 /29/((( 00000
3gis C 0'2''0( 002%(' !!292+' 00000 0'/2909
HM8 022!0!+ 00/0.+2 .'+90'9 00000
!M/ &0(0(/(/ 00'..+2 &!+/9(! 00000
2MW2# &00..('/ 00/!%! &0%(!/0! 0'%92
3l*+ C 0(%0'. 002./+% 2+(%0(+ 00000 022(.2!
HM7 &00%!9+' 00.'!09 &!90!/'2 00/+(
!M/ &0'(./'2 002%%9( &!2(!/2' 00000
2MW2# 00('%!+ 00.%029 !'2%+0! 0!%..
34"+s C &0.9!90' 002(/!+ &!%//0(+ 00000 0220'/.
HM8 0!9!2%2 00.+02! .0(% 0000!
!M/ 0.%.!(9 00'20% !/092.' 00000
+M:+F 0../0'/ 00/0/(9 %%00.%+ 00000
(orrasEoe C 09.'9/2 00!!+2( %0.9%% 00000 002/+!'
HM8 &00/'20! 00209!2 &2/..099 00!!!
!M/ 00'%.+/ 00!'99/ 2+.90+( 000(!
2MW2# &0000'!2 002!%/2 &00!.2+% 09%%(
(ote4 C 09'+%// 00!+.!+ /'%.(!. 00000 0!'/+'+
HM8 00%/%%/ 00'0%!( 2+%+0!( 000/.
!M/ 00/9029 00209+/ 2%!.2'9 000/0
+M:+F 0'/.%.9 00'!.+2 !!2+.92 00000
Fardenia C 0!(9/+( 00/!0%9 ''!92/' 000!0 0!0%%'(
HM7 0!''0(9 00%%%/! !.9+(/( 0!'/0
!M/ &0'++/%. 00(!+/2 &(!!./09 00000
2MW2# &00+92+ 00%92.( &0%%%222 0'+.9
H+*et C 022../. 002/!'+ %929!%/ 00000 0/(%9/2
HM8 &0'.+.+( 00..(+! &+++%(09 00000
!M/ 0+9!/%' 00'0%/2 2/(/+' 00000
+M:+F 0092'(' 00..2%2 20%/%0/ 00'+'
GonD+* C 0+%(+/. 00'9%92 !9+2202 00000 02!%0(
HM7 &009090/ 00+'0.2 &!2../(( 02!..
!M/ 029.'(9 00/+(2' /!0%/+( 00000
+M:+F 0.+00'/ 00/+'0! %2029%. 00000
Aina*ar C 0((.2(/ 002(!0. 2/..+2+ 00000 0'/''!/
HM8 &0(2+!(2 00.+(/9 &!'!/92( 00000
/+
!M/ 0!+2%+ 00'2992 /2'9+' 00000
+M:+F &0!'2299 00//(99 &2'+/2.. 00!+9
6ariable
Coefficien
t !td. Error t"!tatistic &rob. +"s0uared
Mol C 0(./'/9 00209(' '0+%/+ 00000 0'!/+%
HM8 &0.9+//9 00'(9/( &!'.('/% 00000
!M/ &0'9%'% 002/2. &!/+%''( 00000
2MW2# 00'/9.. 00'+9'( 09.+.9+ 0'.'(
Mtele.o* C 0/+99!% 0022+22 2//2!+% 00000 0.//'(
HM8 &02(!9!( 00.00/% &(/'%.'2 00000
!M/ &0./.'2+ 002+'/9 &!((0(0% 00000
+M:+F 0.%+00! 00.!!2 !!%.''' 00000
@tp C 0(9!.(! 0020!( '.29%!9 00000 0/0../2
HM8 &022!/'! 00'//.! &(2''!2' 00000
!M/ &0'(!2'2 002.2+. &!.%%!.! 00000
+M:+F 0(0++0% 00'(.%. !((/+0/ 00000
Pannon
3nergy C 0..(!92 00'2+9 !'(0+/! 00000 0!(20('
HM8 &0!/(%0. 00/+%+ &2+09/%9 000(9
!M/ 0'%9((+ 00'9'!' 99!200' 00000
+M:+F 0/+0%(% 00(022 9.+9+0% 00000
Phyla4ia C 0!.'.%. 00'//09 .0.0%!' 0000! 0!02(+
HM8 0.%!2!/ 00(2%/+ +(//(%( 00000
SMB &00(20/. 00.29+2 &!...0. 0!.9!
+M:+F 022+'/' 00(.0+/ '/.%2'. 0000.
$a"a C 0''0%0+ 002.2/! !'(.0(9 00000 0/+0+0(
HM8 0!%.(!' 00.2+/' .'!%!0. 00000
!M/ 09'.2%/ 00292 '!99/9% 00000
+M:+F 02!2'! 00.'%%+ .%'+(2! 00000
$ichter
Fedeon C 0!29%09 00''22( '90(+9' 0000! 0!%0'22
HM8 &02//%(. 00/%/+( &.'(%!09 00000
!M/ &0/..'!. 00.000( &!'(0/(( 00000
+M:+F &020//!' 00(0!29 &'.!+%+ 0000+
5ynergon C 0+!%%22 002!+/% ''0'+2+ 00000 02'2(!.
HM8 &0.+000% 00'%'/+ &!22/''+ 00000
!M/ 0!(+9'! 002(!9% (.!0!.+ 00000
+M:+F 0!2/%.9 00'9'+/ '!9(!%% 000!.
T;G C 0+0!'%9 002.('! 2%.+/'( 00000 0'%+%!
HM8 0/.9'9 00.'!++ !2+2.!2 00000
!M/ &02//'!' 0029((/ &%(0(.% 00000
+M:+F 0'/.'2' 00..2% %00!9!% 00000
H%ac. C 099(/+% (/($&0/ !/!992% 00000 0!(+9/+
HM8 &000!!'! 0000!!/ &9%!.!' 00000
!M/ &0000.++ +%.$&0/ &(0%(2+! 00000
+M:+F 0000!// 0000!!% !'0(0%% 0!920
)a4le 95 Summary ta4le of regression of the ' factors on the 2' Hungarian shares
/%
- 8iitations of the !tudy
7imitations of this study are numerous Most importantly6 the studies that ; relied on for
e9amining anomalies are outdated )he pu4lication itself of an anomaly makes it
disappear6 as ar4itrageurs rush to take ad1antage of <hate1er truth it held
Another distortion to my study is that stock trading produces <inners and losers 0nly
those losing stocks that reco1er are included in this study6 4ut stocks <hose companies
default are neglected )his pro4lem is not specific to this paper alone6 4ut most pu4lished
articles ignore defaulted companies
)his leads to theories that e1ol1e around the certainty of market reco1ery
A study of the Hungarian stock market seems ill&fated from the outset )he market lacks a
history that <ould pro1ide sufficiently long time&series of data to <ork <ith Since the
re1i1al of the Budapest Stock $9change in !990 constant change of the stocks on trade
characterised the stock market )he Hungarian market is also difficult to analyse 4ecause
<ith the e9ception of the . ma=or shares6 it is not a li,uid market in comparison to the
de1eloped stock markets %0N of the BUI inde9 is amassed in . shares6 of <hich 2 accrue
(0N the inde9 ;n addition6 currently .! shares are traded all together )his makes
comparison to the US market unrealistic> therefore6 dra<ing comparisons in stock
4eha1iour and de1elopment is an unfortunate task None the less6 ; found that
transplanting #ama and #rench8s findings to the Hungarian market did unleash insightful
results
)o e9amine the reasons underlying the identified anomalies6 <e ha1e to search the
fundamentals ;n this thesis6 ; merely identified some of the o41ious e9planations Get it
might 4e of significance to search for the real ,uestion5 to <hat e9tent are these market
mispricings premiumsV Ao they compensate ?il@li,uidity6 risk or are markets truly
inefficient to uphold the efficient market hypothesis Accepting the criticism or refuting it
/9
is also a 1ery interesting topic to research study Unfortunately6 these ,uestions are 4eyond
the scope of this thesis
4 Conclusion
;n this thesis6 ; introduced asset pricing models )he 4irth of these models came hand in
hand <ith a theory 4olstering informational efficiency "e re1ie<ed the e9tended
literature that challenges the efficient market hypothesis "hen market prices de1iate from
their theoretical pricing6 they are du44ed as anomalies and in1estors rush to take ad1antage
of the state of dise,uili4rium #ama and #rench de1ised a multifactor model that is ,uite
successful in incorporating anomalies in their asset pricing formula
)he researcher duo says6 ho<e1er6 that these anomalies are actually premiums of distress
)heir pu4lished papers ha1e sho<n that characteristics of stocks such as market
capitalisation and 4ook&to&market e,uity are appropriate pro9ies for distress Aistressed
firms may 4e more sensiti1e to certain 4usiness cycle factors6 like changes in credit
conditions6 than firms that are financially less 1ulnera4le )his means that in1estors are
<illing to gi1e up on some e9pected return in e9change for in1estments that are resilient to
market tur4ulences )his causes the premium in small siFe and high B$-M$ stocks "ile
#ama and #rench propose that the t<o factors8 loadings determine price mo1ements6
Aaniel and )itman suggest that it is not factor sensiti1ities6 4ut the characteristics
themsel1es that are responsi4le for market yields
)he critics of the multifactor model re4uke that empirical testing <as specific to the set of
data e9amined 4y #ama> therefore its high precision in forecasting asset returns is not a
coincidence 0thers <ho place emphasis on the psychology of in1estors 4elie1e in the
ne<ly emerging 4eha1ioural finance $1entually6 in1estors are humans6 <ith emotions and
intuitions6 and sometimes make irrational in1estments )his deems modelling of price
mo1ements to 4e far from precise
)he 1ery de4ate o1er the e9planations of anomalies ga1e me the impulse to test the
rele1ance of the model on the Hungarian market My approach <as to apply the formula to
(0
the emerging Budapest Stock $9change shares using an un&am4itious time series from
Septem4er 200' till March6 200% )hrough empirical tests on the Budapest stock e9change6
; find that the return of small and high B$-M$ stocks does yield a premium "hen
regressed on the single stocks6 )he SMB and HM7 factors are positi1e on a1erage6 ie the
three factor model produced significant loadings6 indicating the model8s 1alidity for the
period tested 0n the other hand6 the specifics of the Hungarian market suggest that e9cess
returns account for li,uidity premiums rather than compensation for distress
;n my opinion6 it is easier to find e9planations of past returns <ith the 4enefit of hindsight
;dentifying mispricings in the spot market re,uires kno<ledge and hard <ork6 and often
times luck )his is <hy trading can 4e re<arding& or may4e not
)he ,uestion that remains open is an ongoing de4ate that financial literature is still una4le
to resol1e5 <hich aspects of the siFe and 1alue factors are responsi4le for e,uity premia6 is
it the characteristic itself or the co&1ariation in returns related to siFe and 4ook&to&market
e,uity 4eyond the co&1ariation e9plained 4y the market return ; think this issue has
opened ,uestions that <ould ,uench the thirst of researchers for some time
(!
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th
#e4ruary6
200%@
(/
%ppendi7 1
Hierarchical cluster analysis according to e,uity capitalisation using <ithin&groups linkage
and $uclidean distance
((
Hierarchical cluster analysis according to 4ook&to&market e,uity ratio using <ithin&groups
linkage and $uclidean distance
(+
%ppendi7 2
2@@
# 2@@'
2@@
*
SH $*0N$) BH #0)$I SH $*0N$) BH #0)$I SH $*0N$) BH #0)$I
$H$P $H$P #022AS-0$ 2ABA
#022AS-0$ #022AS-0$ HUM$)
HA2A$N;A HUM$) K0N]UM
K0N]UM K0N]UM PANN$2HG
PANN$2HG PANN$2HG
SM HUM$) BM AANUB;US SM HA2A$N;A BM AANUB;US SM *S$P$7 BM AANUB;US
PHG7AI;A $H;S KPA*K $H;S $H$P $H;S
SGN 7;NAMA2 PHG7AI;A 7;NAMA2 HA2A$N;A 7;NAMA2
M07 SGN M07 KPA*K )3K
0)P 2ABA PHG7AI;A
2ABA )3K SGN
)3K
S7 *S$P$7 B7 $7MU S7 *S$P$7 B7 $7MU S7 $IBUS B7 $7MU
$IBUS M)$7$K0M $IBUS M)$7$K0M M07
KPA*K 2H 0)P M)$7$K0M
]"A*K 2H 0)P
]"A*K 2H
]"A*K
2@@
- 2@@4
2@@
5
SH $*0N$) BH )3K SH $H$P BH SH $*0N$) BH )3K
$H$P $*0N$) $H$P
#022AS-0$ $IBUS $IBUS
K0N]UM #022AS-0$ #022AS-0$
PHG7AI;A K0N]UM K0N]UM
2ABA PHG KPA*K KPA*K
SM $IBUS BM PANN$2HG SM HUM$) BM AANUB;US SM PHG7AI;A BM AANUB;US
HUM$) AANUB;US 2ABA $H;S 2ABA $H;S
KPA*K #0)$I $7MU SGN $7MU
SGN 7;NAMA2 #0)$I #0)$I
M)$7$K0M 7;NAMA2 7;NAMA2
]"A*K M)$7$K0M M)$7$K0M
)3K PANN$2HG 2H
S7 *S$P$7 B7 $H;S S7 *S$P$7 B7 M07 S7 *S$P$7 B7 M07
HA2A$N;A $7MU HA2A$N;A 0)P HA2A$N;A 0)P
M07 SGN 2H HUM$) PANN$2H$G
0)P ]"A*K ]"A*K
2H

( portfolios formed each year according to siFe and 4ook&to&market e,uity
(%