Results for “investment capm” 7 found
Investment CAPM and returns anomalies
We develop a parsimonious general equilibrium production model in which heterogeneity in a small set of firm characteristics coherently explains a wide range of asset pricing anomalies and their linkages. The supply and demand of capital of each firm and equilibrium allocations and prices are available in closed form. Even in the absence of frictions, the model produces a security market line that is less steep than the CAPM predicts and can be nonlinear or downward-sloping. The model also generates the betting-against-beta, betting-against-correlation, size, profitability, investment, and value anomalies, while also fitting the cross-section of firm characteristics.
That is from a recent paper by Sebastian Betermier, Laurent E. Calvet, and Evan Jo, “A supply and demand approach to equity pricing.” As with my other posts on investment CAPM, I am not saying this new approach is either correct or useful, as I genuinely do not know. It’s just that I don’t see too many new ideas in economic theory these days, so when I do I am happy to give them attention.
Another take on q-factors and investment CAPM
Standard consumption CAPM applies a constant discount rate across all stocks, but surely that is odd if different companies face different costs of capital, as indeed they do. Take the companies with a higher cost of capital — in equilibrium they also should have higher rates of return as an offset. And those are (usually) the small stocks, and indeed we know there is a small stock premium (sometimes better expressed as a lower market to book premium) in the finance literature.
But that premium comes from the supply side arbitrage conditions, not from some odd properties of portfolio risk.
You will note that “the investment CAPM says that controlling for a few characteristics is sufficient to explain the cross section of expected returns.” Theory advocates claim that investment CAPM indeed passes that test: “…most anomalies turn out to be different manifestations of the investment and profitability effects.”
That is all from this Lu Zhang paper. Here is my earlier post on q-factors and investment CAPM, still not sure I understand it!
q-Factors and Investment CAPM
The new paper by Lu Zhang with that title strikes me as potentially important, though I am just starting to grasp the main argument. So far I understand it as such. The great weakness of finance theory has been that it assumes asset pricing and the production side of the economy, and production adjustments, are entirely separable. But maybe they are not, and in a way that matters for asset pricing anomalies.
Let’s say that an asset price rises too high, above its fundamental value. The old story was that arbitrageurs sell short and force the price back down. The new story is that investment (sometimes) pours into the overpriced firm, increasing the number of shares and thereby pushing the price of those shares back down. (The opposite may hold for underpricing.)
But sometimes the new investment does not pour in, the overpricing remains, and that can give rise to eventual asset pricing anomalies. Such anomalies in fact arise from imperfections on the investment side, and that explains why asset price anomalies a) tend to cluster around stocks of a common kind in common sectors, and b) do not last forever, because the investment inflexibilities are not forever either. In any case, the Q-factor approach, unlike consumption CAPM, explains where the anomalies come from (and why they might end). Consumption CAPM is sadly quite deficient when it comes to explaining cross-sectional variation in returns across stocks.
Most generally, this “investment CAPM” theory is pricing assets from the perspective of their suppliers — firms — rather than their demanders. Doesn’t this sentence make some sense to you?: “Tim Cook most likely has more impact on Apple Inc.’s market value via his operating, investing, and financing decisions than many Apple Inc. shareholders like me via portfolio decisions in their retirement accounts.”
You will note that when expected investment is high/strong relative to current investment, the model predicts “momentum and Roe premiums.”
I still don’t understand most of this! And apologies to the author for any misstatements. In any case I am intrigued. Here are further papers by Zhang on this topic.
Eight simple (too simple) reasons why I don’t like CAPM
The Capital Asset Pricing Model specifies that the expected return on an asset is a function of the market rate of return plus another factor ("Beta") for the covariance of that asset with the market portfolio. The intuition is that pro-cyclical assets are riskier and thus they must give you higher expected return. But I don’t buy the whole Beta bit, especially not for equity markets:
1. For the marginal investor today, the marginal utility of money doesn’t vary much across world-states. Let’s say you expect to earn a few million dollars over your lifetime and you have access to capital markets. How much do you care about the covariance of a single stock?
2. Tossing in any second variable will improve predictive performance of the model. To me the broader multi-factor models just look like data mining.
3. I can see that Beta might lower the expected return to holding gold, a traditional safe harbor in tough times. I just don’t believe Beta matters for most equity assets. Yes construction is pro-cyclical but does this affect real world thinking about which stocks to buy? I think views on cyclicality are dwarfed by idiosyncratic expectational factors about particular facts of the world.
4. Unlike say, profit maximization, CAPM-reasoning will not evolve in the marketplace unless people are at some level aware of the fundamental principals of the theory and take care to minimize systematic risk. If you are ignorant of CAPM you might have lower utility but you needn’t earn less money over time. You don’t drop out of the marketplace as a broken down beggar.
5. People compartmentalize their fears. Insofar as you worry about systematic risk it will affect your human capital decisions and real estate decisions, not your equity investments.
6. Risk affects your equity investments by getting you to diversify. The story ends there. Greater fear might mean you buy more individual stocks, but you don’t look into their Betas to prefer one stock over another.
7. Did I mention that ex post Beta is not always accurate as a predictor of future Beta?
8. Fama and French have shown that the line connecting Beta and expected returns has an almost flat slope, at least if we adjust for the size of a firm relative to its book value.
For risky equity assets in the United States, my preferred economic model is simple. Expected return equals seven. That is my model, "Seven."
Plus of course an random or error term. How’s that for Occam’s Razor?
Redux, my CWT with SBF
I won’t indent:
COWEN: I have some crypto questions for you. Is there, in fact, any way to coherently regulate stablecoins? I see what the proposals say: It’s all about capital requirements, deposit insurance, treat it as a bank account, like a new kind of money market fund. Can that possibly work? Doesn’t it end up having to be applied to all of crypto, all payments companies, PayPal, whatever else? What’s really there that they can do?
BANKMAN-FRIED: That’s a really interesting question. First of all, I will say, I think there is something that does work compared to the current environment, but I’ll get to your point — it’s actually a good one. If you just said, “Look, all stablecoins have to be fully backed by the dollar and have to have audits to confirm that they are in a bank account,” that would get a pretty safe product that was well understood, well regulated, and frankly would be, from a product perspective, just as good as current stablecoins. That’s what all the stablecoins are doing today.
It’s a mess because there’s no clear regulatory framework for them to fit into and to have oversight of that. So, part of my answer there is, basically, yes, I think that framework would solve the current problems that people have in a pretty clean way. But you have a good point there, which is, how about PayPal? There are all these things that we don’t call stablecoins right now, that we call something else.
COWEN: PayPal promises me a dollar, and they give it to me. I’m happy, right?
BANKMAN-FRIED: Exactly. In fact, a lot of these look a lot like stablecoins when you drill into it. When you really dig into it, what is the difference between PayPal and USDC? I guess there’s some differences, but I think there are more similarities than there are differences, to be honest. What does that imply for PayPal? You can just say, whatever it implies, stablecoin is not PayPal — it’s how it is.
I think there would be a big improvement over the current world, where it’s the same thing but without regulatory oversight and with a lot of random drama because of this. But I do think that it gets to this question of, “Wait, but banks are allowed to rehypothecate dollars. Banks are allowed to do all manner of wacky things with their deposits.” Are stablecoin companies allowed to? If not, is it obvious they shouldn’t be allowed to? And how should that be governed and regulated?
Maybe the answer is, whatever: The banks will do that on their behalf, the banks where they hold their assets, and then pay them interest for the right to do that — although, of course, right now banks aren’t actually paying interest, really . . .
COWEN: Not to me. Also, how stable does a stablecoin have to be to be regulated as such? If there’s any regulatory definition, won’t a lot of people just camp their crypto assets to be just slightly more volatile than wherever the line is drawn, or you’d just end up regulating all of crypto? How does that work?
BANKMAN-FRIED: This could go in a few ways. Is your thought that people will attempt to get just barely into the regulatory system or just barely out of it?
COWEN: Maybe both, but a lot of people will go out of it. So I’ll issue something. I’ll call it a “not stablecoin,” but de facto, it will be very stable. But also, “Oh, it’s just sort of an accident. Oh, who knows what the markets going to do today?” It’s just stable for decades. How do you regulate that?
BANKMAN-FRIED: Oh, that’s a really good question. Of course, what it gets you is this question of, what if a stablecoin didn’t promise to be a stablecoin? Is it bad that it’s backed by the dollar? Does it somehow make it worse from a regulatory perspective? Why is it being held to a higher standard?
COWEN: Exactly.
BANKMAN-FRIED: I do think there’s a little bit of an answer here, although I also think that this is getting at another point, which is, you could reasonably say, “Look, are consumers doing what they’re doing with their eyes wide open?” If there’s sufficient disclosures and transparency, shouldn’t people be allowed to use stablecoins with some risk in them?
I think that’d be a reasonable thing to think, but if you put that aside for a second, you say, “No, absolutely not.” Here’s one difference between that and the stablecoin, which I think is relevant, is that a stablecoin is not just stable in one direction. It’s stable in both directions. In particular, if you’re an investor, and you buy a stablecoin, you have downside risk but not upside. If somehow the stablecoin company makes money, you’re probably not going to get any of that, but if it loses money, somehow, you’re probably on the hook for that.
So, there is something a little asymmetric going on here for the consumer. I think it wouldn’t be crazy from that perspective to think that there should be some protection here and that maybe there should be regulation if consumers are only given one side of exposure, but I don’t think that’s obviously true. I think you’re making a decent point.
COWEN: Now, if we look at DeFi, there are some forms of obvious, explicit leverage, like people borrow money to participate in the system. But those aside, I’ve learned over my life, if you look at any system, any institution, typically there are forms of hidden implicit leverage in those institutions. Might be good, might be bad, but it’s there, and in a sense, you don’t understand the institution until you understand where’s the implicit leverage in this game. In DeFi, where is the implicit leverage? Is it rehypothecation, or where is it? What is it?
BANKMAN-FRIED: Ignoring the explicit leverage of borrow-lending protocols —
COWEN: Yes, which is easy to see, right?
BANKMAN-FRIED: Which is easy to see, yes. So, what happened in 2008? What caused the collapse in a lot of things? That’s sort of a dumb question, but one of the things that led to this is that no one knew how much leverage there was, really, in the system. As you said, there’s always implicit leverage, and in this case, it was all of these bespoke OTC swaps between banks that basically didn’t get reported anywhere. In fact, those got rehypothecated again and again and again. No one was keeping track of the total notional fees. It was impossible to — they weren’t public.
One thing you could do is look for a similar thing in crypto. You could look for OTC transactions. You could look for OTC swaps that live on. You could look at OTC borrow-lending. Those are in crypto. Are they in DeFi? It’s sort of ambiguous — they touch all areas of the crypto ecosystem.
But that’s an area where I think there’s some dubiously accounted-for leverage. I think that’s one answer to that question. Where else is there leverage that sort of is implicit? Rehypothecation sometimes, although in DeFi, because it’s all on-chain, it has to be pretty explicit if it’s going to be rehypothecated, but you’re not . . .
COWEN: But it’s hard to see, right? If you traced everything, you could find it, but no one’s actually watching it. Or are they?
BANKMAN-FRIED: Well, they’re halfheartedly watching it maybe, is how I’d put it, which is not great. Maybe full-heartedly watching it. I could imagine arguing for people full-heartedly watching it, and that would be a reasonable thing for them to be arguing for. In particular, if someone releases a protocol, there’s a question of, well, is that protocol rehypothecating? You just look at the code and see if it can rehypothecate, right?
In general, people actually often do know whether each protocol individually can rehypothecate, which is a separate question from whether they, as a group, can or whether they are or something. But in fact, most of these aren’t. Most DeFi protocols are not doing things beyond what they literally say they’re doing, and so the amount of leverage they introduce into the system mostly is what they say they are.
But here are some hidden things. First of all, you take one leverage thing, you put in another leverage thing, so DAI. DAI is an algorithmic stablecoin. Like other algorithmic stablecoins, it is not perfectly stable. It’s not perfectly stable because it’s not backed by the US dollar. It’s backed by crypto assets that could have price movements. It’s very overcollateralized. DAI can then be used as collateral on some borrow-lending protocols in crypto. That’s one form of rehypothecation in DeFi markets that you can trace through. It is, in theory, public, but it’s not super easy, necessarily, to trace through.
COWEN: Now, for mathematical finance, as you know, we at least pretend we can rationally price equities and bonds. People started with CAPM. It’s much more complicated than that now. But based on similar kinds of ideas — ultimately arbitrage, right? — if you think of crypto assets, do we even have a pretense that we have a rational theory of how they’re priced?
BANKMAN-FRIED: With a few of them, not with most. In particular, let’s talk about Dogecoin for a second, which I think is the purest of a type of coin, of the meme coin. I think the whole thing with Dogecoin is that it does away with that pretense. There is no sense in which any reasonable person could look at Dogecoin and be like, “Yes, discounted cash flow.” I think that there’s something bizarre and wacky and dangerous, but also powerful about that, about getting rid of the pretense.
I think that’s one example of a place where there is no pretense anymore that there is any real sense of how do you price this thing other than supply and demand, like memes versus — I don’t know — anti-memes? I think that more generally, though, that’s happened to a lot of assets. It’s just less explicit in a lot of them.
What is Elon Musk’s greatest product ever, or what’s his most successful product ever? I don’t think it’s an electric car. I don’t think it’s a rocket ship. I think one product of his has outperformed all of his other products in demand, and that’s TSLA, the ticker. That is his masterpiece. How is that priced? I don’t know, it’s worth Tesla. It’s a product people want, Tesla stock.
COWEN: But the prevalence of memes, Dogecoin, your point about Musk — which I would all accept — does that then make you go back and revisit how everything else is priced? The stuff that was supposed to be more rational in the first place — is that actually now quite general, and you’ve seen it through crypto? Or not?
BANKMAN-FRIED: Absolutely. It absolutely forces you to go back and say, “Well, okay, that’s how cryptocurrencies are priced. Is it really just crypto that’s priced that way?” Or maybe, are there other asset classes that may claim to have some pricing, or purport to, or people may often assume it does, but which in practice is not exactly that? I think the answer to that is a pretty straightforward yes.
It’s a pretty straightforward answer that you look at Tesla, you look at a lot of stocks right now, you think about what determines their market cap — the discounted cash flow? Yeah, sort of, that plays a role in it. That’s 30 percent of the answer. It’s when we look at the meme stocks and the meme coins that we feel like we can see the answer for ourselves for the first time, but it was always there in the other stocks as well, and social media has been amplifying this all over the place.
COWEN: Is this a new account of how your background as a gamer with memes has made you the appropriate person for pricing and arbitrage in crypto?
BANKMAN-FRIED: Yeah, there’s probably some truth to that. [laughs]
Here is the full dialogue.
Eric Falkenstein’s *Finding Alpha*
The subtitle is The Search for Alpha When Risk and Return Break Down. I definitely liked this book. It's the best readable summary I know of why CAPM fails (see my comments here). Market data do not, upon examination, show a close connection between risk and return, at least not once you start moving out on the risk spectrum beyond T-Bills and the like. It's not just the famous Fama and French papers, it is worse than you think. I also like the author's "relative status" theory for why many people enjoy risk; it reminds me of Reuven Brenner, a neglected economist to this day.
More controversially, Falkenstein believes the equity premium is zero or near zero. I see it as positive but equilibration does not occur for at least two reasons. First, people don't like the thought that they are losers, and second, their spouses can criticize their investment decisions when temporary nominal losses come and last for years. In this sense my non-EFM view differs from his.
I recall someone in the blogosphere asking why this book does not overturn modern finance. It is a very good book. For it to "stick" it would need a clear empirical test of the relative status model of risk-taking vs. other models. We don't yet have that and I am not sure we ever will. There are too many conjectures consistent with Beta not much mattering for stock market returns and I am not sure the relative status model offers unique predictions within the realm of financial theory. The relative status model offers plenty of testable, and often confirmed, predictions elsewhere, but once we drop EFM we're in a world where choice and risk are context-dependent and we still have to prove it is relative status-driven risk-taking which regulates equity returns. That's very hard to do.
Here is one summary of the book. Here is Eric Falkenstein's blog.
Uncovered interest parity — why does it fail?
This is one of the most puzzling puzzles in macroeconomics: that foreign-exchange speculators are not very good at linking domestic money and bond markets to the foreign exchange market. Not enough money seems to be engaged in betting that a currency with a high nominal interest rates will not decline in value fast enough to make investing in its securities unprofitable. Why not? It’s an easy thing to do.
James Hamilton [correction: *Menzie Chinn*] adds more. What are the main hypotheses for why high nominal interest rate currencies appear to outperform the market?
1. The so-called "peso problem." Someday the roof will cave in on these currencies. The Asian financial crisis was only a small disruption compared to what will happen someday. Our current data set is incomplete and does not represent the real population.
2. Holding crummy currencies is riskier than CAPM and variants indicate. Most likely, the relevant investors are not and cannot be well-diversified. So their high pecuniary returns are offset by the risk they bear. If thirty percent of your wealth is in the South African Rand, the relevant measure of your risk may be the variance of that currency, not the covariance of that currency with some broader international market portfolio. Economic theory usually measures risk by looking at the latter.
3. Many investors stay away from crummy, high nominal interest rate currencies for fear of what their wives (or bosses, consider an agency problem at a financial firm) would say, should they lose money. The relevant markets are segmented. This is linked to #2.
4. This used to be a puzzle, but now the profit opportunity has been identified. The supposed additional risk of the high nominal interest rate currency is phantom. People now jump into high nominal interest rate currencies, at least when such investments are appropriate to restore an equilibrium of risks and returns. We should expect the paradox to disappear in future data sets.
Observation: Do not ever write or say "CAPM model." Do not ever write or say "ATM machine."