MFIN 305: Quantitative Methods of Finance

Fall 2020-2021
Fama-French Three-Factor Model
Accompanying Eviews Workfile on Moodle: otcfx.wf1

1. The Fama-French Three-Factor Model

In a seminal contribution to the finance literature, Fama and French (1993) show that excess
stock returns are driven by three factors (in the cross-section): the excess return on the market,
the returns on small capitalization minus big capitalization stocks (referred to as SMB and known
as the “size factor/effect”) and the returns on high book-to-market minus low book-to-market
stocks (referred to as HML and known as the “value factor/effect”).

Fama and French (1993) employ the latter two additional factors (relative to the CAPM) based
on the observation that small capitalization (known as “small caps”) and high book-to-market
(known as “value stocks”) stocks tend to yield returns that exceed the market’s return.

The Fama-French three factor model is given by:

𝑅𝑡 − 𝑅𝑓𝑡 = 𝛼 + 𝛽𝑀 (𝑅𝑀 − 𝑅𝑓𝑡 ) + 𝛽𝑆𝑀𝐵 𝑆𝑀𝐵𝑡 + 𝛽𝐻𝑀𝐿 𝐻𝑀𝐿𝑡 + 𝑢𝑡

where Rt is the simple return on fund i in month t, Rft is the monthly risk-free rate in month t and
SMBt and HMLt are, respectively, the size and value factors (effects). Fama and French (1993)
compute SMBt as the returns on a portfolio in which the investor is long small capitalization
stocks and short large capitalization stocks. You may think of SMBt as being 𝑆𝑀𝐵𝑡 =
𝑙𝑎𝑟𝑔𝑒 𝑐𝑎𝑝
𝑅𝑡𝑠𝑚𝑎𝑙𝑙 𝑐𝑎𝑝 − 𝑅𝑡 . Therefore, SMBt is an excess return. Fama and French (1993) compute
HMLt as the returns on a portfolio in which the investor is long high book to market (B/M)
ℎ𝑖𝑔ℎ 𝐵/𝑀
stocks and short stocks with low book to market (B/M) ratios. That is, 𝐻𝑀𝐿𝑡 = 𝑅𝑡 −
𝑙𝑜𝑤 𝐵/𝑀
𝑅𝑡 and HMLt is also an excess return.

Note that failure to reject the joint null hypothesis 𝐻0 : 𝛽𝑆𝑀𝐵 = 0, 𝛽𝐻𝑀𝐿 = 0 for a fund implies
that the CAPM is more adequate than the Fama-French three-factor model for modeling the
excess returns on that fund.

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To estimate the Fama-French three-factor model, you should use the following steps:

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The Eviews output from estimating the Fama-French model is given by:

In order to assess whether the fund has a value tilt, the following individual hypothesis should be
tested:

𝐻0 : 𝛽𝑆𝑀𝐵 = 0

𝐻1 : 𝛽𝑆𝑀𝐵 ≠ 0

Using the p-value associated with the coefficient 𝛽̂𝑆𝑀𝐵 of 0.000, the null is rejected at
conventional levels of significance (i.e., at an α of 10%, 5% and 1%) and therefore the fund has a
size tilt. More specifically, the positive sign of the 𝛽̂𝑆𝑀𝐵 = 0.944758 indicates that this fund
invests in small cap stocks. This is not surprising given its name (OTCFX is the T. Rowe Price
Small Cap Fund)

In order to assess whether the fund has a value tilt, the following individual hypothesis should be
tested:

𝐻0 : 𝛽𝐻𝑀𝐿 = 0

𝐻1 : 𝛽𝐻𝑀𝐿 ≠ 0

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Using the p-value associated with the coefficient 𝛽̂𝐻𝑀𝐿 of 0.7979, the null is not rejected at
conventional levels of significance (i.e., at an α of 10%, 5% and 1%) and therefore the fund
doesn’t have a value tilt.

2. Comparing the CAPM and Fama-French Models

The joint test of hypothesis:

𝐻0 ∶ 𝛽𝑆𝑀𝐵 = 0 𝑎𝑛𝑑 𝛽𝐻𝑀𝐿 = 0

𝐻1 ∶ 𝛽𝑆𝑀𝐵 ≠ 0 𝑜𝑟 𝛽𝐻𝑀𝐿 ≠ 0

can be seen as a method of determining whether the CAPM or Fama-French models are more
adequate for a given fund. It should be clear that if the null is not rejected, the CAPM is the more
adequate model for the fund in question.

We examine next how to test this joint restriction “By Hand” or using Eviews:

2.1. Method one: “By Hand”

We impose the restriction under H0 to obtain the restricted regression.

The restricted regression is given by:

𝑅𝑡 − 𝑅𝑓𝑡 = 𝛼 + 𝛽𝑀 (𝑅𝑀 − 𝑅𝑓𝑡 ) + 𝜇𝑡

The above equation is clearly the one for the CAPM. Therefore, imposing H0 yields the CAPM.
To estimate the CAPM, we use the following steps:

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T

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The output from the restricted regression (i.e., CAPM) is given by:

The unrestricted RSS is: URSS (Fama French) = 33.95912

The restricted RSS is: RRSS (CAPM) = 341.6877
𝑅𝑅𝑆𝑆 − 𝑈𝑅𝑆𝑆 𝑇 − 𝐾
𝑡𝑒𝑠𝑡 𝑠𝑡𝑎𝑡𝑖𝑠𝑡𝑖𝑐 = ×
𝑈𝑅𝑆𝑆 𝑚
Using m = 2, K= 4, T=74

test statistic = 317.1608

F- Critical (2, 70) (for α= 5%) = 3.14 (by interpolation)

Given that the test statistic exceeds the Critical value, we reject the null hypothesis. This implies
that the Fama-French model is more adequate than the CAPM for modeling the returns on the
OTCFX fund. This conclusion should not be surprising in view of the high significance of the
size factor.

2.2. Method Two: Using Eviews

The restriction under H0 can also be tested using Eviews built-in capabilities.

The following is a demonstration of how you can do that:

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Note that the F-statistic obtained using the “By-hand” approach and computed by Eviews are
identical. The p-value associated with the F-statistic indicates that the null hypothesis is to be
rejected at any conventional level of significance. Therefore, the Fama-French model is more
adequate than the CAPM model for modeling the returns on the OTCFX fund.