Mrk Horvth

Budapest University of Technology and

Economics, Department of Stochastics,
Hungary

Andrs Urbn
Budapest University of Technology and
Economics, Department of Finance,
Hungary

Compare four asset pricing methods:
Historical average of returns
Capital Asset Pricing Model (CAPM)
Carhart Four-Factor Model
Growth Optimal Pricing Model (GOPM)

Basis of comparision:
Squared error

T
t
d
i
i
i
t
i
t
R Var
R E
1 = 1
) (
2 ) ( ) (
1,
) (
) ( E
investor
Covariances
Expected returns
Portfolio
optimization
Market portfolio
Expected returns
Forward optimization
Reverse optimization
time
RT ET
expected
return
realized
return
past
future
2 ) ( ) (
1,
) (
i
t
i
t
R E
time
past
future

=
1
1 =
) ( ) (
T
t
i
T
i
T
R E
time
past
future
) ) ( ( =
) (
) ( ) (
) ( ) ( f
T
M
T
i
T
f
T
i
T
r R r E E |
) (
) , (
=
) (
) ( ) (
) (
M
T
M
T
i
T
i
T
R Var
R R Cov
|
time
) ) ( ( =
) (
) ( ) (
) ( ) ( f
T
M
T
i
T
f
T
i
T
r R r E E |
= ) (
) (M
T
R E

1
1 =
) (
T
t
M
t
R
Market return is memoryless
Market volatility has memory
Exponential weigthed moving covariance
( )( ) { } ( )
( ) ( ) ) (
~
1 ) , (
~
) , (
~
1 ) , (
~
) (
1
2
) ( ) (
1
) ( ) (
) (
1
) (
1
) ( ) (
1
) ( ) (
1
) ( ) (
i
T
i i
T
M
T
i
T
M
T
i
T
M M
T
i i
T
M
T
i
T
R r a V R R R R r a V
R R v o C R R R R R R v o C


+
)
`

=
+ =
o o
o o
) (
) , (
=
) (
) ( ) (
) (
M
T
M
T
i
T
i
T
R Var
R R Cov
|
) ( ) ( ) ( ) ) ( ( =
) ( ) ( ) ( ) (
) (
) ( ) ( ) (
T
i
T
i
T
i f
T
M
T
i f
T
i
T
MOM mom HML h SMB s r R r E E E E E + + + |
) ) ( ( =
) (
) ( ) (
) ( ) ( f
T
M
T
i
f
T
i
T
r R r E E |
Maximizing wealth level:
0 1 1
) 1 ( ... ) 1 ( ) 1 ( = W R R R W
T T T
+ + +

T
TG
t
R
T
t
t
T
t
T
e W e W R W W
0
) 1 ln(
1 =
0
1 =
0
= = ) 1 ( =
+

[
+
) 1 ln(
) 1 ln(
1
=
1 =
T
t
T
t
T
R E
R
T
G
+
~ +

) (
) (
) (
) (
1
1
)
1
1
, ( 1
= ) (1
M
T
M
T
i
T
i
T
R
R
R Cov
R
+
+

+
E
E

=
1
1 =
) ( ) (
T
t
i
T
i
T
R E
) ) ( ( =
) (
) ( ) (
) ( ) ( f
T
M
T
i
T
f
T
i
T
r R r E E |
) (
) (
) (
) (
1
1
)
1
1
, ( 1
= ) (1
M
T
M
T
i
T
i
T
R
R
R Cov
R
+
+

+
E
E
) ( ) ( ) ( ) ) ( ( =
) ( ) ( ) ( ) (
) (
) ( ) ( ) (
T
i
T
i
T
i f
T
M
T
i f
T
i
T
MOM mom HML h SMB s r R r E E E E E + + + |
Standard and Poors 500 constituents
weekly returns
Assets
January 1970 December 2008
Interval
US Treasury Bill 1 month
Risk-free
rate
NYSE, AMEX and NASDAQ capitalization
weighted average, including dividends
Market
index
0},
) (
) (
) (
) (
{ :
1 = 1
) (
2 ) ( ) (
2,
) (
2 ) ( ) (
1,
0
=

=
T
t
d
i
i
i
t
i
t
i
i
t
i
t
R Var
R E
R Var
R E
H
E E
Method SNSE diff. Students p-value

Four-Factor Average


311

2.15%
CAPM - Four-Factor 104 39.05%
GOPM - CAPM 51 3.33%