Robert A. Korajczyk

Performance measurement with the arbitrage pricing theory : A new framework for analysis

This paper develops a theory and econometric method of portfolio performance measurement using a competitive equilibrium version of the Arbitrage Pricing Theory. We show that the Jensen coefficient and the appraisal ratio of Treynor and Black are theoretically compatible with the Arbitrage Pricing Theory. We construct estimators for the two performance measures using a new principal components technique, and describe their asymptotic distributions. The estimators are computationally feasible using a large number of securities. We also suggest a new approach to testing for the correct number of factors.

Risk and Return in an Equilibrium Apt: Application of a New Test Methodology

We use an asymptotic principal Components technique to estimate pervasive factors influencing asset returns and to test the restrictions imposed by static and intertemporal equilibrium versions of the arbitrage pricing theory (APT) on a multivariate regression model. The empirical techniques allow for fairly arbitrary time variation in risk premiums. We find that the APT provides a better description of the expected returns on assets than the capital asset pricing model (CAPM). However, some statistically reliable mipricing of assets by the APT remains.

Assessing the Market Timing Performance of Managed Portfolios

A number of techniques have been proposed to measure portfolio performance and to distinguish between performance due to forecasting security-specific returns and performance due to forecasting market-wide events. We show theoretically and empirically that it is possible to construct portfolios that show artificial timing ability when no true timing ability exists. In particular, investing in options or levered securities will show spurious market timing. These types of securities will also induce the negative correlation between measured selectivity and timing ability found by others. We suggest specification tests to help distinguish between spurious and true timing ability. In addition, the tests can be used to distinguish between different models of the managers reaction function.

Do Arbitrage Pricing Models Explain the Predictability of Stock Returns

This article studies predictability in U.S. stock returns for multiple investment horizons. The authors measure to what extent predictability is driven by premiums for economywide risk factors, comparing two standard methods for factor selection. They study single-beta models and multiple-beta models. The authors show how to estimate the fraction of the predictability in returns captured by the model simultaneously with the other parameters. Their analysis indicates that the models capture a large fraction of the predictability for all of the investment horizons. The performance of the principal components and the prespecified-factor approaches are broadly similar. Copyright 1995 by University of Chicago Press.

Equity Issues with Time-Varying Asymmetric Information

This paper develops a formal model of the effect of time-varying asymmetric information on the timing and pricing of equity issues when managers are better informed than outside investors. We assume that as time passes, the adverse selection problem becomes more severe as more managers receive a private signal. Under this assumption, the model predicts temporal variation in the quantity of issues, with a bunching of issues after information releases. It also predicts that the price drop at issue announcement increases with the time since the last information release. These predictions are consistent with several recent empirical studies relating equity issues to earnings and dividend announcements.

The Pricing of Forward Contracts for Foreign Exchange

This paper investigates the nature of observed deviations from the unbiased expectations hypothesis in the forward foreign exchange market. If these deviations are due to risk premia then the same premia should be observed in nominal bonds denominated in different currencies. This condition imposes testable restrictions on the parameters of a mutivariate regression model. The empirical results are consistent with a world in which time varying risk premia cause the observed deviations from unbiased expectations.

Predicting Equity Liquidity

In this paper we develop a measure of liquidity, price impact, which quantifies the change in a firms stock price associated with its observed net trading volume. For a large set of institutional trades we compare out-of-sample, characteristic-based estimates of price impact to actual price impacts. Predictive predetermined firm characteristics, chosen to proxy for the severity of adverse selection in the equity market, the non-information-based costs of making a market in the stock, and the extent of shareholder heterogeneity, include relative size, historical relative trading volume, institutional holdings, and the inverse of the stock price. We find numerous aspects of trade execution which are significantly related to the price impact forecast error in economically plausible ways: For example, the predicted price impact overestimates the actual price impact for very large trades, for trades executed in a more patient manner, and for trades where the institution pays higher commissions.

The Attributes, Behavior, and Performance of U.S. Mutual Funds

This article examines the risk and return characteristics of U.S. mutual funds. We employ an equilibrium version of the Arbitrage Pricing Theory (APT) and a principal-components-based statistical technique to identify performance benchmarks. We also consider the Capital Asset Pricing Model (CAPM) as an alternative. We implement a procedure for overcoming the rotational indeterminacy of factor models. This procedure is a hybrid of statistical factor estimation and prespecification of factors. We estimate measures of timing ability for the CAPM and extend it to the APT. We find that this timing test is misspecified due to noninformation-based changes in mutual fund betas. We develop a modification of the timing measure that, under certain conditions, distinguishes true timing ability from noninformation-based beta changes.

Factor Models in Portfolio and Asset Pricing Theory

The foundation of modern portfolio theory is the mean–variance portfolio selection approach of Markowitz (Journal of Finance 7:77–91, 1952; Portfolio Selection: Efficient Diversification of Investments, Wiley, New York, 1959). We discuss the role of factor models in implementing portfolio selection, defining the nature of systematic risk, and estimating the premium for risk bearing.

Chapter 4 The arbitrage pricing theory and multifactor models of asset returns

Publisher Summary The Arbitrage Pricing Theory (APT) of Ross, and extensions of that theory, constitute an important branch of asset pricing theory and one of the primary alternatives to the capital asset pricing model (CAPM). This chapter discusses the theoretical underpinnings, econometric testing, and applications of the APT. The APT is based on a simple and intuitive concept. Rosss basic insight was that a linear factor model of asset returns, in an economy with a large number of available assets, implies that idiosyncratic risk is diversifiable and that the equilibrium prices of securities will be approximately linear in their factor exposures. The chapter focuses on factor modeling of asset returns. The APT relies fundamentally on a factor model of asset returns. Theoretical derivations of the APT pricing restriction and the evidence from estimates and tests of the APT are also presented in the chapter. APT has led to new work in mathematical economics on infinite-dimensional vector spaces as models of maw-asset portfolio returns, and the properties of continuous pricing operators on these vector spaces. It has led to econometric insights about what constitutes a factor model, and how to efficiently estimate factor models with large cross-sectional data sets. It has underpinned an enormous body of empirical research on asset-pricing relationships, and on related topics such as performance measurement and cost of capital estimation.