CAPM states that expected return on a specified stock can be divided into two components, the risk-free rate of interest and a term multiplying the price of risk times the quantity of risk in the stock. The consequence is that low-beta stocks have higher returns and high-beta ones have lower returns than the theory predicts. Besides, CAPM suggests that the best passive portfolio strategy is to hold a value weighted market portfolio.
During the 70s, everyone was looking for inefficiencies to beat the market. For Black and Scholes, there is evidence on mispricing stocks suggesting the existence of a factor called the alpha effect. Indeed, low-betas stocks were underpriced and high-beta ones overpriced.
In order to exploit the anomaly, Black and Scholes proposed three strategies more efficient than the high-beta strategy:
The first is a market portfolio levered to have the same risk as the high-beta portfolio.
The second is a portfolio of low-beta stocks levered to have the same risk as the high-beta one.
The third is a mixture of long positions in low-beta stocks and short positions in high-beta stocks.
B for Neo: what does "three strategies more efficient" mean?
ReplyDeleteNeo has missed one big story. Black and Scholes believed that the inefficiency was the result of borrowing constraints. This means that people might know how to make the most profits, but they can't borrow enough money to make the profitable investments they know are out there.
So, at the end of the section, where Black and Scholes propose their 3 portfolios for their tests, their first portfolio is only low beta stocks. By definition, this will have low returns (even if those low returns are higher than they really should be). By borrowing, they are increasing the return of their entire portfolio.
I would not have used the word "consequence" in the second sentence. If anything, this is an anomaly.
Everyone is still looking for inefficiencies in the market. We just have a lot more evidence showing that inefficiencies recognized in the past couldn't be exploited to make super-normal profits.
I also wouldn't use the word "factor" to describe the "alpha effect". Factor has a specific meaning in statistics: a weighted average of variables that has predictive power, that has been adopted into finance. I might use "component" instead.
BTW: The alpha in "alpha effect" is the idea covered in class that any super-normal profit will show up in a CAPM estimate as an estimated intercept that is significantly positive.