IB9EN0 Financial Markets

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IB9EN0 Group Project 
UNIVERSITY OF WARWICK 
MSc Accounting and Finance 
IB9EN0 FINANCIAL MARKETS 
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This project requires you to do hands-on empirical analyses using real financial data and to interpret and discuss the results in words. The quality of the interpretation is as much important as the empirical analyses and results. Active group discussion is strongly encouraged as various opinions from different teammates can enrich the report. For the empirical parts, feel free to use any of the computer programs (e.g., Excel, Stata, SAS, Matlab, or even C++) you are familiar with.

Please keep in mind that this task is all open-ended: there is no guarantee that you end up having similar empirical results to what have been documented previously in the literature. As long as you are certain about the analyses, there is no point spending much time trying to replicate the existing results. Just proceed with your findings and try to interpret them by relating them to the concepts learnt in class.

I. Data Description

Historical monthly returns of individual stocks

• See the spread sheet under the name of ‘Stock Return’.
• This data is downloaded from the CRSP at WRDS (Wharton Research Data Services, the link: http://wrds-web.wharton.upenn.edu/wrds/).
• 50 stocks in Chemistry Industry are chosen from the universe of stocks traded in the U.S financial markets (i.e., NYSE/AMEX/Nasdaq).
• The price is measured at the end of each month.
• The monthly return in a percentage form is computed as: (the price at the end of current month/the price at the end of previous month) – 1.
• The market value of the firm is computed by (the share price)×(the number of shares outstanding) for the month.
• The sample spans 13 year-long period from July 1992 to June 2005, which gives us the data panels of 7,800 (50×13×12) observations.

Three Risk Factors

• See the spread sheet under the name of ‘Risk Factor’.
• This data is downloaded from Ken French’s website (the link: http://mba.tuck.dartmouth.edu/pages/faculty/ken.french/data_library.html)
• MKT is the monthly excess returns in a percentage form on the market that is measured by value-weighted return of all available stocks in the markets.
• Two other variables, SMB and HML (both are the monthly returns of size- and book-tomarket portfolios, respectively, in a percentage form) are the size- and book-to-market factors introduced by Fama and French (1992). The Fama-French three factor model is essentially the augmented CAPM with these two additional factors.
• RF is the monthly returns of risk-free assets (i.e. T-bills) in a percentage form, which can be used to compute the excess returns of the stocks or portfolios.
• The sample period is matched to that of the individual stock returns.

Market-to-Book Ratio (ME/BE)

• See the spread sheet under the name of ‘Book Value’.
• This data is computed by Gi Kim using the data downloaded from the COMPUSTAT at WRDS (Wharton Research Data Services, the link: http://wrdsweb.wharton.upenn.edu/wrds/).
• The book equity (BE) is the accounting value (as opposed to the market measure) of the firm equity.
• The market equity (ME) is the market value of the firm equity, which is the share price times the number of shares outstanding.
• The ratio is computed based on the data of BE and ME at the end of year (as the accounting variables are not updated frequently).

Market Value

• o See the spread sheet under the name of ‘Market Value’, where monthly market value is given.

Historical monthly returns on 49 Industry Portfolios

• o See the spread sheet under the name of ‘Industry Portfolio’.
• o This data is also downloaded from Ken French’s website.
• o The monthly returns are given in a percentage form for 49 different portfolios, each of which contains many stocks in a specific industry, e.g., agriculture, food, books, drugs, etc.

II. Project Questions

Based on the sample of 50 stocks for the period from July 1992 to June 2005, answer the following questions (Question 1 to Question 3).

Testing the CAPM

1. Following early studies of testing the CAPM (e.g., Linter, 1965), estimate the two-pass regression to test the CAPM empirically. Based on your results from both a first-pass (time-series) and a second-pass (cross-sectional) regression, discuss in detail whether you would reject the validity of CAPM.
2. To overcome the measurement errors in estimating beta, re-do Question 1 by following the BJS approach (Black, Jensen and Scholes, 1972) to construct portfolios. Discuss in detail whether and how the results may change.

Small Firm Effect & Value Effect

3. Appraise critically the claim of ‘β is dead’ by Fama and French (1992) by examining whether there exist the small firm effect and the value effect.

Fama-French Three Factor Model

Using the sample of 49 industry portfolios for the period from July 1992 to June 2005, answer the following question (Question 4).

4. Discuss the relative performance of asset pricing model for the CAPM vs. the FF 3-factor model. You may do this by comparing the out-of-sample forecasting power between the two models.

III. Selective References

Black, F., M. C. Jenson, and M. Scholes, 1972, The Capital Asset Pricing Models: Some Empirical Tests, in M. C. Jensen, ed., Studies in the Theory of Capital Markets. Praeger, New York, 79-124. (Web Link: https://papers.ssrn.com/sol3/papers.cfm?abstract_id=908569)

Fama, E.F. and K. French, On the Cross-Section of Expected Returns, Journal of Finance, 1992, Vol 47, 427466.

Fama, E.F. and K. French, Common Risk Factors in the Returns on Stocks and Bonds, Journal of Financial Economics, 1993, Vol 33, 3-56.

Fama, E.F. and K. French, Size and Book-to-Market Factors in Earnings and Returns, Journal of Finance, 1995, Vol 50, 131-155.

Fama, E.F. and K. French, Multifactor Explanations of Asset Pricing Anomalies, Journal of Finance, 1996, Vol 51, 55-84.

Fama, E.F. and J.D. MacBeth, Risk, Return, and Equilibrium: Empirical Tests, Journal of Political Economy, Vol 81, No 3, 607-636.

J. Lintner, 1965, Security Prices, Risk and Maximal Gains from Diversification, Journal of Finance, Vol 20, No 4, 587-615

IV. Guideline for Writing the Report

Word count: the report should not exceed the word limit of 4,000 (excluding the captions for figures and tables)

Format: The report includes only the answers to each question. That is, the report does not have to follow the typical structure (abstract, introduction, literature review, or conclusion) that proper academic papers would have. However, cite the references properly if used to support the answers.

1. Explain in detail the empirical procedures and the intuition/rational behind them.
2. Report the empirical results using figures and tables in a proper way (title, caption, etc.).
3. Interpret and discuss the results in detail, and in an intuitive (not a mechanical) way.

• Analytical ability to apply the proper empirical methods
• Problem solving ability to produce the accurate results
• Critical ability to reflect and appraise on the results
• Presentation ability to express ideas and arguments fluent and well