Michael Dempsey

The Capital Asset Pricing Model (CAPM): The History of a Failed Revolutionary Idea in Finance?

The capital asset pricing model (CAPM) states that assets are priced commensurate with a trade-off between undiversifiable risk and expectations of return. The model underpins the status of academic finance, as well as the belief that asset pricing is an appropriate subject for economic study. Notwithstanding, our findings imply that in adhering to the CAPM we are choosing to encounter the market on our own terms of rationality, rather than the markets.

The book-to-market equity ratio as a proxy for risk: Evidence from Australian markets

Crucial to the interpretation of the Fama and French three-factor model is the question of whether the book-to-market equity ratio should be assigned as a ‘risk-based,’ as opposed to a ‘mispricing’ explanation of share price formation. In the context of Australian stock markets, we examine the role of the book-to-market equity ratio in the formation of stock returns. Notwithstanding the distinctive characteristics of Australian markets, our findings are complementary with findings for U.S. stocks. We succeed in revealing a strong association between stock returns and the firm’s book-to-market equity ratio, and find strong evidence that the association derives from the book-to-market ratio’s absorption of the implications of market leverage as a risk factor. In addition, we determine evidence of mispricing as contributing to the formation of market leverage itself.

The Cost of Equity Capital at the Corporate and Investor Levels Allowing a Rational Expectations Model with Personal Taxations

This paper argues that the conventional definition of the cost of equity at the corporate level is likely to be fundamentally flawed under conditions of personal taxation. A dimensionally consistent definition is developed utilising the pioneering contributions of Auerbach and Elton and Gruber. Consequent benefits are straight-forward expressions for the cost of equity capital at the corporate level (for both retained earnings and new equity) as well as at the investor level (post personal tax) in terms of both the dividend discount and CAPM-type models, which are applicable to classical and imputation tax systems. A fundamental framework is thereby provided which succeeds in illuminating investor personal tax liabilities as they might be expected to impact on a firms investment and related dividend policies.

Australian Superannuation (Pension) Fund Product Ratings and Performance: A Guide for Fund Managers

This paper investigates the ability of Morningstar superannuation fund ratings to predict future performance in the context of the Australian superannuation fund industry. In this context, we make provisions for fund size and fund age. We draw three broad conclusions. First, fund ratings can assist in predicting funds that are likely to significantly underperform in subsequent periods. Second, the ratings are mostly unable to distinguish between highly and moderately performing funds. Third, the likelihood of a fund being highly rated is negatively related to the size of assets under management and positively related to its age. Accordingly, the paper should be of benefit not only to fund managers seeking to identify underperforming funds, but also to fund advisers, retail investors, and trustee boards choosing SF products for investment choice menus.

The CAPM: A Case of Elegance is for Tailors?

“If you are out to describe the truth, leave elegance to the tailor.” Albert Einstein (Nobel Prize for Physics, 1921) This article appeared in the Abacus journal as a response to the commentaries on my article “The Capital Asset Pricing Model (CAPM): The History of a Failed Revolutionary Idea in Finance?” that appeared in the same issue of the Abacus journal (Vol. 49, 2013), and which was aimed at highlighting what I perceived as three “pretences” in asset pricing: (1) the “pretence” at the very beginning of the fanfare for the CAPM that claimed that the data supported at least a version (Black’s model) of the model, (2) the present “pretence” that modern asset pricing can somehow be maintained as some kind of extension or refinement of the CAPM, and (3) the “pretence” that these studies are meaningfully relevant to an understanding of actual capital markets.

Special Dividend Announcements: Signaling or Free Cash Flow Hypothesis‘ Evidence from UK Firms

We examine the impact of special dividend announcements for UK firms over the period 1989-2007. We find that the market reacts positively to the announcement of these dividends, but that the reaction is stronger for firms with lower growth opportunities (low Tobin’s q). For lower-growth firms, we do not find any evidence that the firm is using a special dividend to signal future cash flow performance. Rather, it appears that these firms are using a special dividend to distribute cash that is surplus to its needs, consistent with agency theory. For special dividend issuing firms with higher growth opportunities (high Tobin’s q), we find evidence that such firms subsequently enjoy improved cash flow performances (for both the fiscal year-end immediately after, and the fiscal year following, the announcement date), thereby supporting a signaling hypothesis for special dividends. Overall, our findings offer support for both the free cash flow hypothesis and the signaling hypothesis. That is, managers use special dividends to signal future cash flow performance for firms with high growth opportunities, while using special dividend to reduce agency costs for firms with low growth opportunities.

Investor protection and market liquidity revisited

Purpose – This paper aims to establish the relation between corporate governance – as represented by investor protection at both the legal and firm levels – and stock market liquidity. Design/methodology/approach – This paper avails of the unique features of Hong Kong- and China-based stocks that are traded on the Hong Kong Stock Exchange so as to test whether differences between “common law” and “civil law” legal environments contribute to differences in stock liquidity. In addition, by constructing an internal corporate governance index score for each firm based on board size, board independence and information on the audit and remuneration committee, we document whether firms with better corporate governance scores have narrower spreads, greater depth and higher trading volumes. Findings – Overall, results provide support for a linkage between corporate governance issues – as investor rights protection at both the environment and firm protection levels – and stock market liquidity. Research limitations...

The Information Content of ASX SPI 200 Implied Volatility

In Australia, the equivalent of a US VIX indicator has recently become available. In response, we consider whether the information captured in the implied volatility of options on the Australian SPI 200 Futures index is superior to the information content of a generalized autoregressive conditional heteroskedasticity (GARCH) approach to volatility prediction. We conclude that the implied volatility of at-the-money (ATM) call options on the SPI 200 Index futures is more powerful, dominating other modes of moneyness options as well as GARCH predictions.

The impact of macroeconomic information releases on the smile shape: Evidence from the Australian options market

Purpose - The purpose of this paper is to assign fair values to options reduces to the attempt to attribute correct implied volatilities. Here, the authors extend the study by Tanha et al. (2014) to determine the impact of macro economic announcements on the option smile. Design/methodology/approach - First, the authors estimate the implied volatility function in terms of moneyness. The authors next analyse the impact of macroeconomic announcements on the estimated coefficients (b0, b1, b2) by regressing the coefficients on the macroeconomic announcements. Findings - The authors find that in-the-money options are sensitive to such announcements, but that out-of-the money options are not. This is consistent with the interpretation of investor behaviour from prospect theory. Originality/value - The systematic pricing errors that have been documented using the Black-Scholes model have stimulated attempts to improve the model predictions. The approach uses DVF model to improve the B-S model.

Is Fundamental Indexation able to time the market? Evidence from the Dow Jones Industrial Average and the Russell 1000

Fundamental Indexation weights stock according to a firm’s economic size, not stock price or market capitalization. This means that, at least in theory, unlike traditional market capitalization weighted indexes, it prevents overinvestment in overpriced stock and vice-versa. It should effectively time the market by avoiding incorrect investment in cyclically mispriced stock. We ascertain if Fundamental Indexation outperforms traditional indexing and whether any outperformance can be attributed to market timing. Using almost fifty years of Dow Jones Industrial Average Index and Russell 1000 Index returns, we find some evidence of limited market timing but no evidence of overall positive abnormal performance.