The size effect is a market anomaly in asset pricing according to the market efficiency theory. According to the current body of research, market anomalies arise either because of inefficiencies in the market or the underlying pricing model must be flawed. Anomalies in the financial markets are typically discovered form empirical tests. These tests usually rely jointly on one null hypothesis H0= markets are efficient AND they perform according to a specified equilibrium model (usually CAPM). Thus, if the empirical study rejects the H0, the reason could either be due to market inefficiency or due to the incorrect model.
Market efficiency theory says that the price of an asset fully reflects all current information and is not predictable (Fama 1970). Fama (1997) states that market anomalies, even long‐term anomalies, are not an indicator for market inefficiencies due to the reason that they randomly split between “underreaction and overreaction, (so) they are consistent with market efficiency” (p. 284), they happen by chance and it is always possible to beat the market by chance.
This essay will give an overview of the literature of the size effect and will stress the key theories, empirical methods and findings, as well as the existing body of research about this particular anomaly.
Table of Contents
1. Introduction
2. Empirical Methods
2. Theories and Concepts
3. Empirical Evidence
4. Reasons for the Size-Effect
5. Conclusion
Research Objectives and Key Topics
This paper provides a comprehensive overview of the "size effect" anomaly within asset pricing theory. It examines the historical discovery of the phenomenon, the evolution of theoretical models designed to explain it, and empirical evidence regarding its persistence or disappearance in financial markets.
- Market efficiency theory and its relation to pricing anomalies.
- Evolution of asset pricing models from CAPM to multi-factor approaches.
- Comparative analysis of empirical methods used to test the size effect.
- Investigation of market frictions and liquidity risks as potential drivers.
- The debate surrounding the disappearance of the size premium in modern U.S. markets.
Excerpt from the Book
2. Empirical Methods
The two major methods of testing the size effect are the cross-sectional linear regression or to categorize size-groups and analyse the monthly returns of each group and compare them (Fama and French 2008). Some studies use a both methods but others only use the regression method. The method of sorting companies is a very straightforward method, which presents a “simple picture” (Fama and French 2008, p. 1654). By using this method, researcher just calculate the mean returns of each group over a specific time period and compare them which each other. However, “A potential problem is that the returns on (...) portfolios that use all stocks can be dominated by stocks that are tiny“ (Fama and French 2008, p.1654).
The cross sectional regression method computes a regression on particular stocks or portfolios. One advantage of the cross-section regression is that it can estimate which “anomaly variable” (Fama and French 2008, p.1654) has what kind of influence on the returns. It is possible to compute minimal effects of each variable. Additionally, according to a diagnostics of the residuals of the regression model it is possible “to judge whether the relations between anomaly variables and average returns implied by the regression slopes show up across the full ranges of the variables” (Fama and French 2008, p.1654). In other words, you can conclude by the different slopes of the regression among the stocks/portfolios if certain anomalies like the size-effect are significant or not.
Summary of Chapters
1. Introduction: Outlines the definition of the size effect as a market anomaly and introduces the fundamental conflict between market efficiency and pricing model validity.
2. Empirical Methods: Discusses the two primary methodologies—categorization and cross-sectional regression—used to identify and analyze the size effect in stock returns.
2. Theories and Concepts: Details the theoretical development of the Capital Asset Pricing Model (CAPM) and the subsequent introduction of multi-factor models to account for size-related anomalies.
3. Empirical Evidence: Presents statistical data and historical studies demonstrating the presence and potential disappearance of the size premium in U.S. markets.
4. Reasons for the Size-Effect: Explores various explanatory factors including arbitrage pricing theory, liquidity risk, and price adjustment delays as possible drivers for the size anomaly.
5. Conclusion: Synthesizes the current state of research and suggests that the impact of firm size on returns remains a subject of ongoing debate and complexity.
Keywords
Size effect, Asset pricing, Market anomaly, CAPM, Empirical tests, Cross-sectional regression, Market efficiency, Equity risk premium, Fama and French, Liquidity risk, Portfolio theory, Financial markets, Market capitalisation, Beta, Price delay.
Frequently Asked Questions
What is the core focus of this research paper?
The paper focuses on the "size effect," a market anomaly where smaller companies often exhibit higher stock returns than larger ones, challenging standard asset pricing theories.
What are the central themes discussed in the work?
The central themes include the evolution of asset pricing models, the methodologies used to empirically test market anomalies, and the debate regarding whether firm size continues to influence stock returns.
What is the primary goal of this research?
The goal is to provide a comprehensive literature review that stresses key theories, empirical findings, and the academic body of research surrounding the size effect anomaly.
Which scientific methods are primarily utilized?
The paper discusses quantitative methodologies, specifically focusing on cross-sectional linear regressions and portfolio categorization based on market capitalization.
What is covered in the main body of the text?
The main body covers the transition from early CAPM models to multi-factor models, empirical evidence of the size premium, and various theoretical explanations such as liquidity risk and price adjustment delays.
Which keywords best characterize this study?
Key terms include size effect, asset pricing, CAPM, market anomaly, liquidity risk, and cross-sectional regression.
How did Fama and French influence the understanding of the size effect?
Fama and French significantly challenged the CAPM by introducing multi-factor models that include size and book-to-market value as critical variables for explaining asset returns.
What does the empirical data suggest about the current status of the size effect?
The data indicates that while the size effect was prevalent in early periods, many studies suggest it may have diminished or become statistically insignificant in the U.S. market since the 1980s.
What is the role of "price delay" in this context?
Price delay refers to the observation that smaller companies may have slower stock price adjustments compared to larger companies, which can create a "delay premium" that mimics the size effect.
- Quote paper
- Arthur Ritter (Author), 2014, The Market Anomaly "Size Effect". Literature Review, Key Theories and Empirical Methods, Munich, GRIN Verlag, https://www.grin.com/document/299135
