Factor models, risk management and investment decisions

Abstract

The recent extending empirical evidence regarding the power of factor models versus the traditional CAPM has motivated the research in the current thesis. Substantial controversy has been raised over two issues: 1) Are the new factors, market value and book-to-market equity, the most important sources of risk? and 2) Is it time to consider CAPM as a useless model? Effectively, these are the main questions we attempt to address in the current research within a unified framework of firm attributes and more aspects of the econometrical applied approaches. The main findings of the empirical research in this thesis show that, firstly the beta portfolio returns exhibit the highest volatility, confirming thus the beta as the most significant risk source. Secondly, the market portfolio absorbs the excess returns of the majority of value-weighted factor portfolios which is partly attributed to the mitigation of the January effect. In the seasonality area, we identify a strong October effect with high volatility but not high returns, a phenomenon that cannot be explained with a rational story. The re-examination of the Fama and French 1992 model with corrections of econometrical problems and the application of panel data methodology reveals that the sole significant factor over all the candidate variables is the price variable. Yet, even the power of the price factor is eliminating with the application of non-linear systems where the CAPM constraints are directly validated but with a negative sign. However, the presence of negative risk premium is consistent with the valid application of CAPM in a financial world where the occurrence of bad states of world is more frequent than the presence of up markets. Overall, the results of this thesis contribute to a thorough understanding of the factor models' performance which plays a key role in the financial investment decisions. The implication is that the CAPM should be still regarded as the basic financial model in the risk-return management process.