Unformatted text preview:

Business 35150 John H. Coc hraneProblem Set 4 SolutionsPart I readings. Give one-sentence answers.1. No vy-Marx, The Profitability Premium. Preview: We see that gross profitability forecasts returns,a lot; its power is not explained by hml slopes (in fact, hml goes the wrong way.) A “profitabilityfactor” digests a long list of anomalies, just as FF found for HML.(a) − = P−1(∆+− +). Does this sort of identity suggest that variables, such ascurren t gross profitability, whic h ha ve strong power to predict future dividends (or earnings;“good company” variables) should forecast returns better alone, or better in combination withbook/market or similar valuation ratios? (If you run a regression +1=  + + +1andaregression+1=  + + + +1, sometimes including improves x’s forecast power(raises b), and sometimes including low ers 0 forecast power (low ers b). Which is it in thiscase?)A: That’s the whole idea really. Novy-Marx is enchanted with the power of profitability byitself, but both profitability and B/M are mixing two things seen best when they are includedtogether. Higher ∆ by itself can mean just higher p. Higher ∆ control ling for p must meanhigher returns. Abstract.(b) p.5. Fama and French found that profitability did not help to forecast returns. In a one-sentence nutshell (and inspired by the identity), why does Novy-Marx’s measure work som uch better?. (Start with, why is it different? Note, this “true economic profitability” stuffseems farfetched to me. There is something deeper at work.)A: Gross profitability is a better forecast of future earnings. For example, if you’re investinga lot in R&D, that’s a great sign of future earnings, but bad for earnings today.(c) Table 1 Panel A. Are r eturns here regressed on contemporaneous values of the right handvariable, =  + + , or lagged, =  + −1+ ? What’s the punchline of Panel A?A:=  + −1+ ?, the punchline is that gross profitability helps to forecast returns,con t rolling for B/M.(d) What danger does Novy-Marx worry about with Fama-MacBeth regressions, whic h motivateslooking at portfolios? (A little graph might help.)A: p.9 “because they weight each observation equally, put tremendous weight on the nano-and micro-cap stocks, which make up roughly two-thirds of the market by name but lessthan 6% of the market by capitalization. The Fama-MacBeth regressions are also sensitiveto outliers, and impose a potentially misspecified parametric relation between the variables,making the economic significance of the results difficult to judge. ”(e) Table 2. More profitable firms will have higher prices, so just sorting on profitabilit y can isolatelow-return growth firms. If you sort just based on gross profitability, without controlling forB/M, do expected returns still rise with profitability, or do they go the other wa y? Do HMLloadings explain the variation in expected returns?A: Even not controlling for B/M, higher profitabilit y means higher expected returns. HMLloadings go the wrong way.(f) Table 4. Does the power of profit - to asset sorts evaporate in the biggest firms, as “dissectinganomalies” suggested? (Where do we look?)A: Bottom row, top left box panel A. It’s weaker (0.30-0.55) than the top row (0.40-1.07) butstill there.5(g) Table 6 (Important!) Is the profiteffect in average returns strong while controlling forbook/market? Is the value effect strong in average returns controlling for profits? Do hmlbetas (and alphas) explain the value dimension of average returns, controlling for profits? Dohml betas (and alphas) or other Fama French betas explain the profit dimension of returnscont rolling for book to market?A: Top left block, yes and yes. Each effect is stronger controlling for the others, as youwould expect. column (far right) and row (lower block, panel A) yes for value, no forprofitability where hml betas are all the same.(h) Table 10 (Important). Like Fama and French, Novy-Marx wants to know if a factor formedon his anomaly, PMU, can explain a zoo of other anomalies. How many anomalies in Table10 are left unexplained by the FF+momentum model, that Novy-Marx model captures? Hint:What’s the central column of Table 10?) (For counting purposes, we can use t statistics greateror less than two, despite my sermons about t statistics)A: I.e. how many 4are above 2 with  less than 2. I count 11 cases, but the principleand getting you to look at the table is the main thing.2. Fama and French Five Factor model. Reading notes. Fama and French spend a lot of time onshowing you various different ways of doing things to show ho w it comes out the same. Don’tget lost in the variations, first get the basic idea and figure out their point with one way of doingthings. In particular, get the general idea of “factor definitions” section III but don’t get too deepin the different versions. Section V sems the most important to me. I focused on the 32 portfoliosand 2x2x2x2 factors.(a) p.3 FF say “higher expected future earnings imply a higher expected return.” But in a presentvalue model, higher expected earnings can coexist with a constan t expected return — it justgenerates a higher stock price. How can FF say this?A: This paragraph fixes i.e the price. If the price doesn’t change, then higher earningsmust have come with higher expected returns. The point of the question is to review that FFare making partial statements holding things — lik e M — constant. Also p.7 “ The valuationmodel does not predict that B/M, OP, and Inv effects show up in average returns withoutthe appropriate controls.”(b) What are RMW and CMA?A: p.4 the difference between returns on diversified portfolios of stock with robust and weakprofitability and...lo w and high investment .. which we call conservative and aggressive.(c) How do FF define and measure “profitabilit y” and “investment?” Are these in dollars or ratiossomehow?A: p.6. “profitability (measured with accounting data for the fiscal year ending in t-1) is annualrevenues minus cost of goods sold, interest expense, and selling, general, and administrativ eexpenses,alldividedbybookequityattheendoffiscal year t-1.” p.7; “ Inv is the growth oftotal assets for the fiscal year ending in t-1


View Full Document

Chicago Booth BUSF 35150 - Problem Set 4 Solutions

Documents in this Course
CLONES

CLONES

8 pages

Load more
Download Problem Set 4 Solutions
Our administrator received your request to download this document. We will send you the file to your email shortly.
Loading Unlocking...
Login

Join to view Problem Set 4 Solutions and access 3M+ class-specific study document.

or
We will never post anything without your permission.
Don't have an account?
Sign Up

Join to view Problem Set 4 Solutions 2 2 and access 3M+ class-specific study document.

or

By creating an account you agree to our Privacy Policy and Terms Of Use

Already a member?