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Intermediate Finance Project (Slot 4) Usama Humayoon 2013-02-0457 1.

The Fama and French (1993) three factor model was developed as a result of increasing empirical evidence that the Capital Asset Pricing Model (CAPM) performed poorly in explaining realized returns. In fact, Fama and French 1992 paper “The Cross Section of Expected Stock Returns” studied the joint roles of market beta, size, Earnings/Price ratio, leverage and book-tomarket equity ratio in the cross-section of average stock returns for NYSE, Amex and NASDAQ stocks over the period 1963-1990. In that study, the authors find that beta has almost no explanatory power. Fama French therefore argued that if stocks are priced rationally, risks must be multidimensional. As a result, Fama and French in 1993 paper entitled “Common Factors in the Expected Returns on Stocks and Bonds” constructed a three-factor asset pricing model for stocks that includes the conventional market (beta) factor and two additional risk factors related to size and book to market equity. The model says that the expected return on a portfolio in excess of the risk free rate is explained by the sensitivity of its return to three factors: (i) the excess return on a broad market portfolio, (ii) the difference between the return on a portfolio of small stocks and the return on a portfolio of large stocks (SMB) and (iii) the difference between the return on a portfolio of high-book-to-market stocks and the return on a portfolio of low-bookto- market stocks (HML). The model is as follows: R = Rf + beta3 x (Km - Rf) + bs x (SMB) + bv x (HML) + alpha

Where: R is the portfolio's rate of return, Rf is the risk-free return rate, Km is the return of the whole stock market. The "three factor" β is analogous to the classical β but not equal to it, since there are now two additional factors to do some of the work. SMB (small minus big): difference between returns on diversified portfolios of small and large capitalization stocks. HML (high minus low): difference between returns on diversified portfolios of high (distressed firms) and low B/M (not – distressed firms) stocks Moreover, once SMB and HML are defined, the corresponding coefficients bs and bv are determined by linear regressions and can take negative values as well as positive values. It can be seen that the Fama and French three-factor model is more like an extension of the CAPM. The Fama-French Three Factor model explains over 90% of the diversified portfolios returns, compared with the average 70% given by the CAPM. In fact, the model augments the CAPM model by the size effect and the book-to- market equity effect. The size effect is the empirical regularity that firms with small market capitalization exhibit returns that on average significantly exceed those of large firms. The book to-market equity effect shows that average returns are greater the higher the book value to market-value ratio (BE/ME) and vice versa. It is also referred to as the “value premium”. The high book value firms are under-priced by the market and are therefore good buy and hold targets, as their price will rise later. Fama and French analyzed the characteristics of firms with high book-to-market and those with low book-tomarket equity. They find that firms with high BE/ME tend to be persistently distressed and those with low BE/ME are associated with sustained profitability. They conclude that the returns to

Bonds with lower credit quality are subject to the risk of default. As of 2010. describing the market as having three forms of efficiency: strong form. DFA diversify broadly and use a "variable maturity" approach in most of our portfolios. This approach. or sometimes as “glamour” stocks. Based on Fama/French research. DFA was ranked as the overall best performing fund family based on Barron’s/Lipper ranking. The Fama/French research found a way to offset gains and minimize dividends without sacrificing strong diversified exposure to specific asset classes or across asset classes. C) U. To maximize expected returns. The strategies used by DFA are largely based upon research that has been conducted by Eugene Fama and Kenneth French. Bonds that mature farther in the future are subject to the risk of unexpected changes in interest rates.S. 2. Eugene Fama develops a method of shifting maturities that identifies optimal positions on the fixed income yield curve. DFA strategy is to choose shorter maturities in flat or inverted yield curve environments and longer maturities in upwardly sloped curves. uses the current yield curve to determine optimal maturities and holding periods. Small Value investment: Dimensional Fund Advisor value strategies are based on the Fama/French research paper entitled. Maturities are shifted in response to changes in the current yield curve. Extending bond maturities and reducing credit quality increases potential returns. Asset classes that were previously suited to non-taxable investors now make sense for everyone. efficient market. The high book-to-market stocks favored by the strategy became known in the academic literature as “value” stocks while the low BE/ME stocks DFA eschewed became known as “growth” stocks. DFA bases their approach on the efficient market principle and number of others which are: A) One-Year Fixed Income Strategy: With no prediction of interest rates. Relative performance in fixed income is largely driven by two dimensions: bond maturity and credit quality. Since it is impossible to predict what will happen with interest rates in the future. DFA opened new opportunities for taxable investors. Fama is regarded as the father of the Efficient Market Hypothesis. semi strong form and weak form. Dimensional Fund Advisors (DFA) have been growing steadily and profits have been strong. which was developed by Professor Eugene Fama.holders of high BE/ME stocks are therefore a compensation for holding less profitable and riskier stocks. “The Cross-section of Expected Stock Returns” in which he showed that stocks with a high ratio of book value of equity to market value of equity (BE/ME) known as “value” stock exhibited consistently higher returns than stocks with low BE/ME known as “growth” stock and . It argued that value stocks outperformed growth stocks for the only reason any asset consistently outperforms in a rational. B) Tax Management: Dimensional tax-managed strategies implemented to maximize after-tax returns by offsetting gains and minimizing dividends.

the . and particularly in the emerging African stock markets. The Carhart (1997) four-factor models specified as follows. M. The empirical results confirm that the Fama and French (1993) three factor model holds for the Stock Exchange of Mauritius. On Persistence in Mutual Fund Performance: In this paper Carhart introduces The four-factor model used in evaluating fund performance is motivated by Carhart (1997). much as it had introduced international small-stock funds in years past. where the coefficients on the factor-mimicking portfolios indicate the proportion of mean return explained by the four factors. The model used is similar to the Fama-French three-factor model. I have chosen the most significant papers and they are: A) Carhart. D) International value funds: Fama and French again performed a test to show the effect of book to market effect but this time with international data. as well as stock price and stock return information.are designed to capture the return premiums associated with high book-to-market (BtM) ratios.S. Morgan Stanley Capital International had carefully collected data on thousands of firms in dozens of countries. Fama and French analyzed these data and found once more that the book-to-market effect was robust. the model can be thought of as a performance attribution model. One may expect that a Fama and French three-factor that takes into account the time-variation in risk. It also innovates by augmenting the Fama and French three-factor model. This study provides some empirical evidence in an emerging market. As stated there are many papers written improving or adding upon Fama French model. and offers additional out of sample evidence that the size and the book-to-equity effects are international in character. DFA expanded its product offerings by introducing international value funds. lagged by two months. dividends. who finds that the one year momentum anomaly documented by Jegadeesh and Titman (1993) explains the persistence in mutual fund performance documented in prior literature. the significance of the size and book-to-market equity effects may be reduced or even disappear. (1997). R = Rf + beta3 x (Km . High book-to-market stocks outperformed low in virtually every country studied. Moreover. These data included book value. Based on these findings. with additional factor MOM to capture momentum.Rf) + bs x (SMB) + bv x (HML) + bm x (MOM) + alpha SMB and HML factors are calculated as per the Fama-French (1992) three-factor model. ranked on the basis of their prior six-month returns. B) An Augmented Fama and French Three-Factor Model: New Evidence From An Emerging Stock Market by Sunil K Bundoo In this paper it is showed that there is a lack of empirical evidence of whether the size and value premium are present in emerging equity markets generally. DFA’s U. the Stock Exchange of Mauritius. Small Value investment fund is based around this new strategy. and earnings. MOM is a momentum factor which represents the difference in returns between the top and bottom third of All Ordinaries stocks. M. According to Carhart (1997). 3.

Robert J. the FM method found an insignificant return Beta relationship. Abhay Kumar Singh and Robert Powell In traditional tests of asset pricing theory Ordinary Least Squares (OLS) regression methods are used in empirical tests of factor models. Microsoft Stock CAPM calculation Regression Statistics Multiple R 0. we found that the return Beta relationship is insignificant. Replicating the FM methodology. which is often of key interest to investors and risk managers. In particular. D) Asset Pricing. using our methodology we reach different conclusions. using the same data and employing the joint pooled time-series and cross-section estimation. which implies a focus on the means of the distributions of covariates. E) Further Evidence on the Risk-Return Relationship by Yakov Amihud. The study not only shows that the factor models does not necessarily follow a linear relationship but also shows that the traditional method of OLS becomes less effective when it comes to analyzing the extremes within a distribution. Hodrick. their estimate of a negative price of risk of aggregate volatility is consistent with a multifactor model. beyond the mean of the distribution. in the main. the quintile portfolio of stocks with the highest idiosyncratic volatility earns total returns of just -0. This study empirically examines the behaviour of the three risk factors from Fama-French Three Factor model of stock returns. C) The Cross-Section of Volatility and Expected Returns by Andrew Ang. Yuhang Xing. This implies that there is no support for the major dictum of the CAPM However. Allen. and (2) the use of generalized least squares estimation This method of estimation produces more efficient estimates and more powerful tests than those obtained by the FM methodology A recent study by Fama and French (1992) which applied. and Xiaoyan Zhang In this paper they examined the returns of a set of test assets that were sorted by idiosyncratic volatility relative to the Fama-French (1993) model. They uncover a very robust result. However. The work of Koenker and Basset (1982) and Koenker (2005) provides an alternative via Quantile regression featuring inference about conditional quantile functions. However.02% per month in their sample. Bent Jesper Christensen and Hairn Mendelson In this paper they presented two econometric techniques to test the capital asset pricing model (CAPM) : (1) a joint pooled cross-section and time-series estimation procedure.empirical results for the augmented model show that the Fama and French three factor model is robust after taking into account time-varying betas. 4. we obtained a significantly positive coefficient of average return on Beta. consistent with FF. the Fama-French Factor Model and the Implications of Quantile Regression Analysis by David E. Stocks with high idiosyncratic volatility have abysmally low average returns.517847201 . by using quantile regressions and a US data set.

134% Fama French three factor model calculation Regression Statistics Multiple R 0.97785 0.67*6.21 * 2.01116 0.21333387 Expected Return = Rf + beta*(Mkt-Rf) Expected Retun = 2.553441 0.876 Expected Return = 6.003081 Intercept Mkt-RF SMB HML Coefficients -0.16703359 7.998 + -0.205547 -0.223254 -3.23 Expected Return = 2.18E-11 Intercept Mkt-RF Coefficients -0.64 + 1.654 + 1.331922 Adjusted R Square 0.803461 -0.09387 0.21*2.264011 2.317808 Standard Error 9.605538 7.94002 0.876 + 0.47727 1.268165723 0.67225 Expected Return = Rf + beta1*(Mkt-Rf) + beta2*(SMB) + beta3*(HML) Expected Return = 2.218663 0.23% Company X Stock .914397565 146 Standard Error t Stat P-value 0.263083541 9.59402 0.38E-10 0.R Square Adjusted R Square Standard Error Observations 0.329787 0.09*2.348804 0.821497295 -0.80330372 1.539168 Observations 146 Standard Error t Stat P-value 0.576127 R Square 0.165599 6.

374319414 2.945430553 .66 + (-0.554249 Observations 147 Standard Error t Stat P-value 0.017)*3.CAPM calculations Regression Statistics Multiple R 0.68750079 0.076385091 -0.104139399 1.033927398 Standard Error 4.52573208 0.012635647 0.076292461 -0.492880755 0.288239975 0.136119202 Expected Return = Rf + beta1*(Mkt-Rf) + beta2*(SMB) + beta3*(HML) Expected Return = 2.307086489 0.0173356 Expected Return = Rf + beta*(Mkt-Rf) Expected Return = 2.069 + 0.0530518 0.00654 Standard Error 4.053778204 Adjusted R Square 0.22695 0.000355 Adjusted R Square -0.17% .231901282 R Square 0.66 + -0.337 + 0.0.193281245 Intercept Mkt-RF SMB HML Coefficients 0.819459024 0.337 Expected Retutn = 2.288*3.102232369 2.077166233 -0.376228294 2.004852 0.860743 0.136*5.53*3.820781 Intercept Mkt-RF Coefficients 1.018844 R Square 0.6% Fama French three factor model calculations Regression Statistics Multiple R 0.461761527 Observations 147 Standard Error t Stat P-value 0.005493466 0.914 Expected Return = 4.

So the both model are not valid in this case and cannot be relied.07 which suggests that CAPM gives expected risk premium below the actual risk premium by a value of 107%.1.7% risk premium above the actual risk premium.55 which is above 0. Fama and French model fails to confirm to its own predictions as both of its main variable showed no relationship with the actual risk premium (Ri-Rf). On the other hand. . The beta is highly significant as the P-value is well below 0.5. suggesting that both models correctly predict the risk premium on the given security. being insignificant. But this value is insignificant as the P-value is 0. The value of intercept. CAPM seems to be right in its prediction that a security risk premium is dependent upon the risk premium of market portfolio and a security’s beta. SMB is insignificant as its P-value is above 0. The validity of both CAPM and Fama and French models can be judged from the value of intercept. The value of intercept in case of Microsoft stock is -. The beta is also highly insignificant as the P-value is above 0. The intercept has a value of -.80 which suggests that CAPM also gives expected risk premium above the actual risk premium by a value of 80%.1.1.0048 which is below 0. An asset valuation model is considered valid if: 1. The intercept is statistically insignificant. The value of intercept is in case of Company X stock is -.477 which shows that Fama and French model predicts 47. this value is insignificant as the P-value is 0. The value of intercept. However.1. This is against the basic foundation of FF model. The result shows that SMB have no relationship with the dependent variable (Ri-Rf).1. Also this value is significant as the P-value is 0. However.1. the intercept values were insignificant. The intercept has a value of 1. The result shows that HML have no relationship with the dependent variable (Ri-Rf). This is against the basic foundation of FF model. This is why CAPM is the preferred model in our case.1.329 which is above 0. In both of the regression outputs of Fama and French and CAPM. suggests that Fama and French model is valid. HML is insignificant as its P-value is above 0.012 which is below 0. But the one additional variable of Fama and French is insignificant as well.1. Also one additional variable of Fama and French is insignificant as well. The intercept is considered statistically insignificant when its P-value is above 0. Value of intercept is zero or closer to zero OR 2. suggests that Fama and French model is invalid. being significant.94 which shows that Fama and French model predicts 94% risk premium below the actual risk premium. And this value is significant as the P-value is 0.1.

hence leading to the conclusion that the stocks according to R-square are not a viable option. neither affecting the P/E ratio. which can indicate that the company is holding on to profits in hopes of reinvestment. This helps us in this way that it points out the stocks true value. These methods just point out the basic reasons of how and why intrinsic value can be important. and not all of these factors can be incorporated in our statistical analysis. With our experience we have learnt that there is no hard and fast rule in the trading of stocks.One of the major reasons for this is that the R-square of both the stocks is significantly less. A company with a high P/E ratio suggests that the earnings per share of that company are less. Another test that can be very helpful is trying to figure out the intrinsic value of a stock. A company such as this has high capital gains and dividends but both of these things are for the long term. This explains us in general the type of company one is and their policies. In most cases one stock can have a very favorable end whereas the other one having a completely opposite effect. This can be calculated in many different ways. Two similar situations of two different stocks don’t necessarily have the same end. One of the basic tests that we could run to determine which stocks should be traded in is. These companies are suggested to be developing companies which may result in handsome capital gains. by calculating the price to earnings ratio. An undervalue stock is always expected to have a price rise to meet its true intrinsic value because that is what the market values the stock to be. Although the gist of it is to figure out which stocks are overvalued and which undervalued. A company with a low P/E ratio just suggests that it has reached its peak and any chances of earnings with respect to capital gains are meager. whereas an overvalued stock is expected to fall. . We need to consider the fact that in a stock market there are many factors working at hand. This leads to incomplete data and information to run a regression and make a significant decision on the current stocks.