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Downside risk and empirical asset pricing

16-12-2004 | Research | Pim van Vliet, PhD The last decades have witnessed some major developments in the field of asset pricing. These have contributed to a better understanding of stock, bond and other asset prices and have influenced other disciplines such as corporate finance and macro economics. Currently (2004), the Nobel prize winning Capital Asset Pricing Model (CAPM) of Sharpe (1964) and Lintner (1965) celebrates its 40th birthday. This seminal model is the most widely applied model in asset pricing. During the past decades, much progress has been made in the theoretical, methodological and empirical fields of asset pricing. First, several generalizations of the CAPM exist, each based on relaxing one of the main assumptions of the CAPM. Second, advanced econometric techniques and an increase in computer power have made it possible to handle large datasets and to control for several statistical issues. Third, high-quality financial databases have become available and the richness and precision of these databases is unmatched by other economic disciplines.

Still, the CAPM faces some severe empirical difficulties. Specifically, Basu (1977), Banz (1981), Reinganum (1981), DeBondt and Thaler (1985), and Jegadeesh and Titman (1993) among others show that the CAPM fails to explain the returns of several equity investment strategies (e.g. based on accounting data or past returns). Some authors explain the failures of the CAPM with nonrisk-based explanations such as biases in the empirical methodology (e.g. Lo and MacKinlay (1990), MacKinlay (1995) and Kothari, Shanken and Sloan (1995)), or investor irrationality (e.g. DeBondt and Thaler (1987), Lakonishok, Shleifer and Vishny (1994) and Daniel and Titman (1997)), while others take a rational view and explain differences in return with differences in risk (e.g. Fama and French (1996), Cochrane (1996) and Lettau and Ludvigson (2001)).

This research specially considers several empirical and methodological issues typical for asset pricing. We take a rational view and question CAPM’s use of variance as the relevant risk measure. Today there is substantial evidence that returns are typically not normally distributed and that investors are more sensitive to downside than to upside price movements. Alternative downside risk measures, such as semi-variance, may better describe investor preferences. Surprisingly, despite 2 Chapter 1
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