EMF – ASSIGNMENT 2

Pedro Felipe Pinheiro Salgueiro 2099676 / Satvik Kundra 2113707 / Andrew Bonafacia
2017524 / Paul Laboso 2055912 / Contact: Satvik Kunda (s.kundra@tilburguniversity.edu)

Question 1:

SMB has a positive mean (0,186), indicating that during the given period, small-cap stocks
did better on average than large-cap stocks. It shows a consistent trend that small-cap
stocks outperform large-cap stocks on average.
The moderate standard deviation of 3.043 for SMB indicates that on average, the excess
returns of small-cap stocks compared to large-cap stocks vary moderately. A certain amount
of risk is associated with investing in SMB stocks.
HML has a positive mean (0.284), which indicates that value stocks (high book-to-market
ratio) outperform growth stocks (low book-to-market ratio) on average. The standard
deviation of HML is 3.043, indicating some degree of fluctuation around the average. This
suggests that there is a moderate level of risk associated with owning a portfolio that has a
higher weighting toward value stocks than growth stocks.
Factors of Size and Variance (e.g., BIGLoVAR, BIGHiVAR, SMALLLoVAR):
Except for SmallHiVar (-0.133), which has a negative mean and could indicate a negative
average excess return, size, and variance have positive means for the majority of portfolios.
The portfolios' size and variance standard deviations varied, indicating varying degrees of
risk. Higher variance portfolios typically have higher standard deviations, which indicate
higher volatility.
ME variables, such as ME1VAR2, ME2VAR3, and ME3VAR4:
All of the portfolios have positive average returns, indicating that they performed better
than average and are riskier because of their higher standard deviations.
Investors should consider both average returns and standard deviations when evaluating
portfolios. Although a positive average return is important, it should be evaluated alongside
the risk that goes along with it, as symbolized by the standard deviation. Larger standard
deviation portfolios have a larger chance of yielding higher returns, but they additionally
come with a higher risk. Consequently, while making investment decisions investors need to
carefully weigh the trade-off between possible rewards and increased risk. Portfolios with
higher standard deviations may offer higher potential returns but come with increased risk.
As presented in Table 1, all the equity market and equity portfolios maintained a positive
average excess return except for portfolio with small stocks and high variance. In assessing
the standard deviation of the excess returns of the portfolio, the portfolio with small stocks
and high volatility has the highest standard deviation, indicating a higher level of deviation
from the average value.
Table: Descriptive Statistics
Variable Obs Mean Std. Dev. Min Max
SMB 721 .186 3.043 -17.2 21.36
HML 721 .284 2.999 -13.87 12.75
SMALLLoVAR 721 .991 4.2 -22.54 21.658
SMALLHiVAR 721 -.133 9.444 -32.678 48.649
BIGLoVAR 721 .498 3.485 -16.13 13.784
BIGHiVAR 721 .545 6.686 -28.121 25.805
ME1VAR2 721 1.153 5.792 -28.496 31.961
ME1VAR3 721 1.038 6.67 -30.526 37.251
ME1VAR4 721 .774 7.724 -32.487 38.518
ME2VAR1 721 .879 4.161 -24.145 20.804
ME2VAR2 721 1.029 5.336 -28.075 28.94
ME2VAR3 721 1.05 6.055 -30.488 28.528
ME2VAR4 721 .94 6.935 -33.075 29.252
ME2VAR5 721 .345 8.841 -35.404 53.207
ME3VAR1 721 .756 3.801 -19.272 19.319
ME3VAR2 721 .839 4.914 -25.262 23.966
ME3VAR3 721 .988 5.519 -29.207 24.658
ME3VAR4 721 .872 6.277 -31.109 26.77
ME3VAR5 721 .457 8.122 -33.21 32.987
ME4VAR1 721 .716 3.785 -16.848 22.28
ME4VAR2 721 .754 4.524 -25.097 20.794
ME4VAR3 721 .806 5.16 -26.393 21.182
ME4VAR4 721 .765 5.813 -28.122 21.685
ME4VAR5 721 .532 7.659 -29.546 29.59
ME5VAR2 721 .628 4.047 -17.773 15.392
ME5VAR3 721 .579 4.517 -22.223 16.211
ME5VAR4 721 .53 5.105 -24.323 21.319
Question 2:
Table 2: Cross-Sectional Regression
(1)
VARIABLES Beta

Coefficient of MktRF -0.3494*

(0.1771)
Constant 1.4817***
(0.2028)

Observations 25
R-squared 0.1447
Standard errors in parentheses
 *** p<0.01, ** p<0.05, * p<0.1

As we can see from the table above, upon using all 25 portfolios in the sample, the
coefficient if Market Risk Premium or MktRF in the output is -0.3494 and the standard error
is 0.1771. All of the independent variable are statistically significant at the 1% level. 1
percentage point increase in the market risk free rate will decrease the excess return by
0.3494 holding other factors fixed. Economically it makes sense because the additional risk
factor caused by the increase in the beta would lead to uncertainty in the minds of the
investor and thus reducing the excess returns of the portfolio.

The constant term is 1.4817 and the standard error is 0.2028. When it comes to CAPM, the

Fitted Values from CAPM

constant term should be close to the risk-free rate. Since the constant term is statistically
significant, we can see that the intercept is, in fact, different from zero.

As we can see in the CAPM Fit CAPM Fit Assessment

Assessment, the plotted points do not 1.5

follow a pattern and has a low

correlation, it indicates that the CAPM 1

has limitations in explaining the

observed variation in average returns, .5

and there might be other factors

influencing portfolio returns that are
0
not captured by the model. This .6 .8 1 1.2 1.4 1.6
Average Returns Observed
argument is also backed up by the R- Graph 1: CAPM Fit Assessment
squared which is 0.1447 which means that 14.47% of the variability is captured by the
model.

Question 3:
Table: Second-step regression of Fama-MacBeth
(1)
VARIABLES FMB_2Step

Coefficient of MktRF -0.3235

(0.2642)
cons 1.3827***
(0.1880)

Observations 16,525
Number of groups 661
R-squared 0.3602
Standard errors in parentheses
 *** p<0.01, ** p<0.05, * p<0.1
Based on using the two-step Fama-Macbeth regression approach, we get the above table
and graph as the output. The market rate is statistically insignificant at the 1% level but the

Fitted AVerage Returns

constant variable is statistically significant at the 1% level. 1 percentage point increase in the
constant will increase the average excess return by approximate by 1.3827 holding other
factors fixed. Which makes economic sense as the additional risk factor caused by the 61
19
increase in the beta would lead to
uncertainty in the minds of the Model Fit Assessment
61
60 19
investor and thus reducing the
excess returns of the portfolio. 40
0 6
19

.As we can see the effect of the 20

(mean) FittedARV

MktRF on the average excess return

(mean) portret
0 60
19

reduces very slightly once we use

-20
the Fama-Macbeth approach.
-40

The constant term for the variable is

Graph 2 : Model Fit Assessment
1.3827 with its standard error being
0.1880. As previously mentioned, when it comes to CAPM, the constant term should be
close to the risk-free rate. Since the constant term is statistically significant, we can see that
the intercept is different from zero.

Question 4
Upon using the 60-month rolling windows to estimate the beta in the regression, we receive
a set of betas across portfolios. These are as follows:

BIGHiVAR:
N Mean SD Min Max
MktRF beta 661 1.378 0.162 1.116 1.817
Int Risk beta 661 1.228 1.352 -3.704 6.614
Mean MktRF beta: 1.378, Mean Int Risk beta: 1.228
This portfolio seems to have a similar amount of risk to the interest rate risk and market risk
BIGLoVAR:
MktRF beta 661 .612 0.119 .297 .797
Int Risk beta 661 -2.085 0.999 -4.418 1.445
Mean MktRF beta: 0.612, Mean Int Risk beta: -2.085
This portfolio has a negative interest rate risk which means that the portfolio performs well
whenever the interest rates are hiked. This portfolio could be used as a hedge against
interest rates.
ME1VAR2:
MktRF beta 661 1.046 0.269 .362 1.473
Int Risk beta 661 2.337 2.182 -1.263 9.766
Mean MktRF beta: 1.046, Mean Int Risk beta: 2.337
This portfolio has positive exposure to the market risk and a much higher exposure to the
interest rate risk.
ME5VAR4:
MktRF beta 661 1.07 0.072 .905 1.235
Int Risk beta 661 .496 1.147 -1.89 3.247
Mean MktRF beta: 1.07, Mean Int Risk beta: 0.496
This portfolio has a positive exposure to the market risk, however, a lower albeit positive
exposure to the interest rate risk.
SMALLHiVAR:
MktRF beta 661 1.628 0.277 .94 2.422
Int Risk beta 661 4.265 3.240 -2.293 11.852
Mean MktRF beta: 1.628, Mean Int Risk beta: 4.265
This portfolio has the highest interest rate risk out of all the portfolios being at 4.265
SMALLLoVAR:
MktRF beta 661 .711 0.188 .149 .992
Int Risk beta 661 1.959 2.337 -1.928 10.105
Mean MktRF beta: 0.711, Mean Int Risk beta: 1.959
This portfolio showcases a low Market Risk exposure, however, shows a comparatively high
interest rate risk exposure.

In the graph, we can see the

relation between the market beta
and the interest rate beta. The
interest rate beta seems to be more
sensitive and to be positively
correlated with the market beta.
Furthermore, it is possible to see
that the effects on the interest rate
beta come first and then we can see
a more lagged and smaller effect on
the market beta. A cause for this Graph 3: Market and Interest Rate
beta relationship
could be, for example, that in moments when interest rates are down, the overall market
risk is low, and vice-versa. Also, since the government’s monetary policy to change interest
rates comes first, it is natural that the market risk is affected by it as a consequence, thus
explaining the lagged effect.

Table: Second-step regression of Fama-MacBeth using Value-Weighted method

(1)
VARIABLES FMB_2Step

Coefficient of MktRF -0.0785

(0.2633)
Coefficient of Int_Risk -0.0657*
(0.0351)
cons 1.1185***
(0.2045)

Observations 16,525
Number of groups 661
R-squared 0.4935
Standard errors in parentheses
*** p<0.01, ** p<0.05, * p<0.1

As we can see now, after the second step regression of the Fama-MacBeth, the coefficient
for MktRF or Market Risk Premium is -0.0785 and the coefficient of interest rate risk is -
0.0657. The markt rf is statistically insignificant at the 1% level. The cons is statistically
significant at the 1% level. The interest risk rate is statistically insignificant at the 5% level
but is significant significant at the 10% level. This now means that for every percentage
point increase in the Market Risk Premium, the average excess return on all the portfolios
reduces by 0.0785, holding all other factors fixed. This also shows that for every percentage
point increase in Interest Rate Risk, the average excess return on all the portfolios reduces
by 0.0657, holding all other factors fixed. These make economic sense as interest rate hikes
would add uncertainty to the market and reduce portfolio excess returns and increases in
market risk free beta would reduce excess return provided the return on the portfolio stays
the same. (Excess Return = Return on Portfolio – Risk Free rate). In addition the R-squared of
this model is 0.4935 which means that 49.35% of the variability is captured by the model.
Fitted AVerage Returns

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20
13
20

Model Fit Assessment

Based on the Model Fit Assessment
03
20

60

graph given above, we can

93
19

40
interpret that the data shows us
83
19

20
73

(mean) FittedARV2
19

(mean) portret
63

0
19

-20

-40
that the portfolio returns (depicted as portret on the graph) are more sensitive compared to
the average excess returns, thus being more volatile than the average excess returns.

Question 5:
Table: Second-step regression of Fama-MacBeth using Equal-Weights
(1)
VARIABLES FMB_2Step

Coefficient of MktRF -0.3175

(0.2583)
Coefficient of Int_Risk 0.0221
(0.0380)
cons 1.3622***
(0.2110)

Observations 16,525
Number of groups 661
R-squared 0.5139
Standard errors in parentheses
*** p<0.01, ** p<0.05, * p<0.1

As we can see now that we’re using equally weighted portfolios, the coefficient for MktRF or
Market Risk Premium is -0.3175 and the coefficient of interest rate risk is 0.0221. However,
these coefficients are statistically insignificant. This means that for every percentage point
increase in the Market Risk Premium, the average excess return on all the portfolios reduces
by 0.3175, holding all other factors fixed. This also shows that for every percentage point
increase in Interest Rate Risk, the average excess return on all the portfolios increases by
0.0221, holding all other factors fixed. This makes economic sense as increases in market
Fitted AVerage Returns

risk free beta would reduce excess return provided the return on the portfolio stays the
same. (Excess Return = Return on Portfolio – Risk Free rate). In addition, the R-squared of
this model is 0.5139 which means that 51.39% of the variability is captured by the model.
23
20
13
20

Based on the model fit assessment, we Model Fit Assessment

03

can see that the fit of the model hasn’t

20

60
93

changed much. This is also backed up by

19

40
83

the fact that the R-Squared of the two

19

20
second-step regressions of Fama-MacBeth
73

(mean) FittedARV2
19

(mean) portret
arent too different. When we use the
63

0
19

value-weighted method, the R-squared is -20

0.4935 which means that only 49.35% of

the variability is captured and with the -40

Graph 5: Model Fit Assessment

equal-weights method, we can see that the R-Squared is 0.5139, which means that 51.39%
of the variability is captured.

The difference in outcomes between the two models, value-weighted and equally-weighted
methods is because of the fact that in the value-weighted model, the weights of the
portfolios are determined by the weights associated with them. Whereas with the equally-
weighted method, the weights are assigned equally. This could lead to instances where we
find that certain portfolios are given a bigger weight, hence having a bigger influence over
the model. Which is the impact of Market Risk Free beta has a lower effect on the excess
returns than compared to the model where we used the value-weighted method than
where we used the equally-weighted method.

Question 6:
The t-test was employed to statistically test how investors price market risk and interest
rate risk whether it is different in the recession time and when otherwise. The observation
when there was no recession is 14400 while months classified as recession periods are 2125.
As presented below for the market risk rate, the probability value of the test is significant
which indicates that there is difference in how investors price market risk during recession
period and period that are otherwise. Looking at the economic size, it reveals that investors
price market risk higher in recession times (1.155) than non-recessional period (1.113).
Two-sample t test with equal variances
obs1 obs2 Mean1 Mean2 dif St Err t value p
value
MktRF beta by 14400 2125 1.113 1.155 -.041 .009 -4.7 0
USRE~1

The interest rate risk was also examined to see whether investor prices it differently and the
result is presented in the table below. The probability value of the test is significant which
indicates that there is enough evidence to support the alternate hypothesis of the test that
there is difference in how investor responds to interest rate risk during recession period.
The size of the difference indicates that investors price interest rate risk highly in period that
there is no recession (1.310) when compared to when there is recession (0.407).
Two-sample t test with equal variances
obs1 obs2 Mean Mean dif St Err t p
 1 2 value value
Int Risk beta by U~1 14400 2125 1.310 .407 .904 .053 16.9 0