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.

Leseprobe

1. Introduction
2. Empirical Methods
2. Theories and Concepts
3. Empirical Evidence
4. Reasons for the Size-Effect

Objectives and Key Themes

This essay provides a literature overview of the size effect in asset pricing, focusing on key theories, empirical methods, and findings. It examines the anomaly's existence and explores various explanations for it.

The size effect as a market anomaly
Empirical methods for testing the size effect
Theories explaining the size effect (CAPM, Fama-French three-factor model)
Empirical evidence for and against the size effect across different time periods and markets
Reasons for the size effect, including risk premium and liquidity risk

Chapter Summaries

1. Introduction: This introductory chapter sets the stage by defining the size effect as a market anomaly, challenging the market efficiency theory. It highlights that the anomaly's existence points to either market inefficiencies or flaws in the underlying pricing model, typically the Capital Asset Pricing Model (CAPM). The chapter establishes the essay's aim to review existing literature on the size effect, emphasizing key theories, empirical methods, and findings related to this particular market anomaly. The inherent ambiguity of rejecting the null hypothesis (efficient markets and a correctly specified model) is also discussed.

2. Empirical Methods: This chapter details the primary empirical methods used to investigate the size effect: cross-sectional linear regression and size-group categorization with subsequent return analysis. The strengths and weaknesses of each method are discussed. The simple approach of sorting companies into size groups and comparing their average returns is presented, highlighting the potential bias caused by the dominance of very small companies in the portfolio returns. Cross-sectional regression, meanwhile, allows for a more detailed examination of the influence of the "anomaly variable" (size) on returns and facilitates the assessment of the significance of the relationship through residual analysis. This detailed methodology forms the basis for subsequent empirical studies described in the essay.

2. Theories and Concepts: This section delves into the theoretical underpinnings of the size effect, beginning with its initial discovery by Banz (1981). It explains how Banz's work challenged the CAPM by demonstrating a negative relationship between firm size and returns – that smaller firms yielded higher returns. The chapter then explores the criticisms of the CAPM by Fama and French (1992), who showed long-term stock returns differing from CAPM predictions and introduced additional factors (size, book-to-market ratio) into their analysis. This leads to the discussion of the Fama-French three-factor model, which incorporates market risk, firm size, and book-to-market value to explain asset returns more accurately than the original CAPM.

3. Empirical Evidence: This chapter presents a review of empirical evidence surrounding the size effect. It shows that while studies in the period before 1980 consistently found a size premium, this effect seemed to diminish or disappear thereafter in some markets. The chapter presents conflicting evidence from different studies, comparing findings for the US and German markets, as well as highlighting the contradictory results and evolution of this phenomenon in time, showing the significant change in the statistical significance of the size effect over time. The chapter concludes with a discussion on more recent studies indicating continued predictability of the size premium, including cross-national evidence supporting the persistent impact of market capitalization on returns.

4. Reasons for the Size-Effect: This chapter explores potential explanations for the size effect, examining various research attempts to understand why smaller firms tend to outperform larger firms. It discusses different models, including Chan et al.'s (1985) multi-factor model incorporating variables such as inflation, bond yields and risk premia to assess their impact on the size effect. It also covers Acharya and Pedersen's (2005) research which relates the size effect to liquidity risks, arguing that the higher returns of smaller firms can be attributed to their lower liquidity and higher exposure to liquidity risk. The chapter also mentions Hou and Moskowitz's (2005) work linking the size effect to investor behavior and market frictions such as price delays.

Keywords

Size effect, market anomaly, CAPM, Fama-French three-factor model, market efficiency, empirical evidence, liquidity risk, risk premium, asset pricing, small firm effect, cross-sectional regression.

Frequently Asked Questions: Size Effect in Asset Pricing

What is the main topic of this essay?

This essay provides a comprehensive literature review of the size effect in asset pricing. It examines the size effect as a market anomaly, exploring the key theories, empirical methods, and findings related to it. The essay investigates the existence of the anomaly and explores various explanations, including risk premium and liquidity risk.

What are the key themes explored in the essay?

The key themes include: the size effect as a market anomaly; empirical methods for testing the size effect (cross-sectional regression and size-group categorization); theories explaining the size effect (CAPM, Fama-French three-factor model); empirical evidence for and against the size effect across different time periods and markets; and reasons for the size effect (risk premium and liquidity risk).

What are the chapter summaries?

The essay is structured into four main chapters: Chapter 1 introduces the size effect as a market anomaly, challenging the efficient market hypothesis and outlining the essay's objectives. Chapter 2 details the empirical methods used to investigate the size effect, focusing on cross-sectional regression and size-group categorization. Chapter 3 reviews empirical evidence surrounding the size effect, presenting both supporting and conflicting findings across different time periods and markets. Chapter 4 explores potential explanations for the size effect, examining various research attempts to understand why smaller firms might outperform larger firms, discussing models incorporating liquidity risk and investor behavior.

What empirical methods are discussed in the essay?

The essay primarily discusses two empirical methods: cross-sectional linear regression and size-group categorization with subsequent return analysis. The strengths and weaknesses of each method are analyzed, highlighting the potential biases involved, particularly in size-group categorization due to the dominance of very small companies.

What are the key theories used to explain the size effect?

The essay explores the Capital Asset Pricing Model (CAPM) and its limitations in explaining the size effect. It then focuses on the Fama-French three-factor model, which incorporates firm size and book-to-market ratio alongside market risk to provide a more comprehensive explanation of asset returns. Additional models incorporating factors like inflation, bond yields, risk premia, liquidity risk, and investor behavior are also discussed.

What is the empirical evidence regarding the size effect?

The essay presents a mixed picture of empirical evidence. While studies before 1980 consistently found a size premium, later studies show varying results across different markets (e.g., US and German markets). Some studies show a diminishing or disappearing size effect over time, while others continue to find evidence supporting the existence of a size premium. The essay highlights the contradictory findings and the evolution of the statistical significance of the size effect over time.

What are the potential explanations for the size effect?

The essay explores several potential explanations for the size effect, including: liquidity risk (smaller firms are less liquid and thus command a higher return to compensate for this risk), risk premium (smaller firms may be inherently riskier), and investor behavior and market frictions (such as price delays). The essay mentions research by Chan et al. (1985), Acharya and Pedersen (2005), and Hou and Moskowitz (2005) as examples of studies attempting to explain the phenomenon.

What are the keywords associated with this essay?