Power Of Fama And French Three Factor Model Finance Essay

In economic footings, Pratt and Grabowski ( 2008 ) suggest that cost of capital in a peculiar undertaking or investing express an chance cost, in which implies investors will non put in a peculiar plus if there is another higher existent rate of return plus. Hence, it is of import for investors to cognize a concern ‘ cost of capital, which allows them to be able to measure its value and the influences of other schemes before finding the most rational plus to put ( Beneda, 2003 ) .

Many research workers have attempted to construct a dependable theoretical account being able to gauge the cost of capital of securities and show its explanatory power. Although a figure of theoretical accounts were published such as Capital plus pricing theoretical account, Arbitrage pricing theory or Fama and French three factor theoretical account, none of them were wholly acknowledged as a dependable theoretical account. In general, all theoretical accounts try to capture the systematic hazard in gauging the mean stock returns. Among these theoretical accounts, Fama and French is considered as theoretical account which have better explanatory power than the others. However, there are still unfavorable judgments about the theoretical account. In this research paper, I will concentrate on analyzing whether the Fama and French three factor theoretical account have explanatory power in gauging the mean stock returns in a peculiar stock market, which is Sweden stock market.

As the consequences of old researches, which will be mentioned in literature reappraisal, are still controversial, this research will function as spread filler for literature and a suggestion for features of Sweden stock market.

The chief aims of this paper is to happen a statistical important influences of variables in Fama and French three factor theoretical account to the mean stock returns in Sweden stock market and hence fills the spread in literature and findings of features about Sweden stock market. Furthermore, the consequence of this paper might back up the findings of the writers, or possibly the findings will

The foundation for development of Capital Asset Pricing theoretical account was created by Markowitz ( 1952 ) and Tobin ( 1958 ) through Portfolio Theory, which suggests that the hazard of an single security is the standard divergence of its returns. Harmonizing to Markowitz ‘s observations, when uniting two single assets, the entire hazard is non linear, and, hence, if an investor builds a portfolio comprising of different hazard single assets, the hazard of the portfolio ever be less than the amount of each single criterion divergences. Hence, alternatively of keeping a peculiar security, Portfolio Theory facilitates investor in taking a proper portfolio from an efficient set of portfolio by giving efficient frontier.

Base on this theory, Sharpe ( 1964 ) and Lintner ( 1965 ) developed Capital Assets Pricing theoretical account ( hereafter CAPM ) , giving the relationship between rate of return of an single security and its hazard. Sharpe suggests that the non-diversifiable hazard of a capital plus can be measured by its covariance with a portfolio comprising of all hazardous assets in the market, which is alleged “ market portfolio ” . This hazard of market portfolio affects all other hazardous assets in the market, and the term “ beta coefficient ” is used to show this influence. Sharpe introduced a one hazard factor theoretical account, known as CAPM, gauging the rate of return of an single security utilizing merely market hazard as follow:

E ( Ri ) = Rf + I?im { E ( Rm ) – Releasing factor }


E ( Ri ) : Tax return on security I

Releasing factor: Risk-free rate of return

Rm: Market portfolio return

I?i: Beta coefficient

After publication, CAPM has become an of import tool in finance for rating of cost of capital, portfolio public presentation, portfolio variegation, valuing investings and taking portfolio scheme among the others. However, there are a figure of groundss demoing the inaccuracies of the theoretical account. The mix empirical surveies pointed out some jobs of CAPM. Roll ( 1977 ) and Ross ( 1977 ) showed that CAPM is wrong when the market is inefficient. An undistinguished relationship between hazard and expected return can be occurred by even a really little divergence from inefficiency ( Roll and Ross, 1994 ; Kandel and Stambaugh, 1995 ) . Furthermore, Bos and Newbold ( 1984 ) ; Faff et Al. ( 1992 ) ; Brooks et Al. ( 1994 ) and Faff and Brooks ( 1998 ) demonstrated that beta is non stable over clip. Kothari et Al. ( 1995 ) besides argued that the survivorship prejudice of the informations can impact the empirical consequences.

A figure of other theoretical accounts concern about specific issues, such as ( I ) Clare et Al. ( 1998 ) disputes that neglecting to take into history possible correlativities between idiosyncratic returns may impact the consequences ; ( two ) harmonizing to Jagannathan and Wang ( 1996 ) , a larger market portfolio has impact on the consequences ; and ( three ) Kim ( 1995 ) and Amihud et Al. ( 1993 ) suggest that errors-in-the-variables job besides influence the consequences.

Fama and Gallic three factors theoretical account:

An increasing figure of surveies have the same statement that the beta coefficient entirely can non explicate to the full the cross-sectional fluctuation of stock returns. In order to better the one-risk factor theoretical account, several research workers suppose that more variable holding explanatory power in gauging cross-sectional fluctuation of stock returns should be added to the theoretical account such as size ( Banz, 1988 ) , book to market value ratio ( Rosenberg et al. , 1985 ; Chan et al. , 1991 ) , macroeconomic variables and the monetary value to net incomes ratio ( Basu, 1983 ) .

One of the common theoretical accounts beliing the CAPM is multi-factor capital plus pricing theoretical account, which is developed by Fama and French ( 1992 ) . They test the joint functions of beta, size, E/P ratio ( Earning/Price ) , purchase and book to market equity in the cross-section of mean stock returns on NASDAQ, NYSE, and Amex stock from 1963 to1990 period. The consequence shows that beta has about no explanatory power, while size, E/P ratio, purchase and book to market equity are independently important in explicating the mean stock returns. However, when those variables are used jointly, size and book to market equity have important power and the effects of E/P ratio and purchase seem to be absorbed. Therefore, Fama and French argue that if stock is rationally priced, hazard must be multidimensional.

Fama and French ( 1993 ) introduced a three factor capital plus pricing theoretical account for stocks incorporating the conventional market ( beta ) factor and two extra hazard factors related to size and book to market equity. The theoretical account says that the expected return on a portfolio in surplus of the hazard free rate is explained by the sensitiveness of its return to three factors: ( I ) the extra return on a wide market portfolio, ( two ) the difference between the return on a portfolio of little stocks and the return on a portfolio of big stocks and ( three ) the difference between the return on a portfolio of high book to market stocks and the return on a portfolio of low book to market stock. The theoretical account is as follow:

E ( Ri ) – Rf = I?1 A- { E ( Rm ) – Releasing factor } + I?2 A- SMB + I?3 A- HML

E ( Ri ) -Rf represents the extra mean return of stock I, I?1 is the beta coefficient lading for the extra return of the market portfolio over the riskless rate. SMB ( little subtraction large ) is the difference between return on the portfolio of little stocks and return on the portfolio of big stocks in the market. I?2, the coefficient of SMB expresses the sensitiveness of return on stock I to put on the line factor associated with house size consequence. HML ( high subtraction depression ) is the difference between return on a portfolio of high book to market stocks ( stocks with high BE/ME ) and return on portfolio of low book to market stocks ( stocks with low BE/ME ) . I?3, the coefficient of HML shows the extent to which extra return on stock I can be determined by a hazard factor related to BE/ME.

The consequence of size to average stock returns is exhibited in empirical regularity, which returns of small-cap companies significantly exceed those of big companies. This can be explained by the higher hazard created by little companies than big companies. Specifically, little companies are more illiquidity and trading in them requires more dealing cost. Furthermore, little companies ‘ information frequently is insufficiently available, which result in high cost of portfolio monitoring of little companies. However, because of non holding any strict theory explicating convincingly why the size consequence should be added in the theoretical account, all accounts for size consequence are still hypotheses. The book to market equity implies that companies with high book value are under-priced by the market and are hence good bargain and hold marks because their monetary value will lift subsequently. In term of houses with low book value, the deduction is opposite of houses with high book value. Specifically, they should be sold, as their monetary value will diminish in the hereafter. This anomaly undermines the semi-strong signifier efficiency of the market. These two variables explain mean return differences across portfolios that can non explained by beta.

Fama and French ( 1995 ) found out that houses with high BE/ME tend to be steadily hard-pressed and those with low BE/ME have sustainable profitableness. They show that book to market equity and inclines on HLM in the theoretical account present comparative hurt. Firms with persistently low net incomes tend to hold high BE/ME and positive inclines on HML, those with high net incomes tend to hold low BE/ME and negative inclines on HML. Similarly, the hazard and return feature of big and little companies besides are analyzed by Chan and Chen ( 1991 ) . Harmonizing to them, little houses, which seem to be with low public presentation and inefficiently managed, be given to be riskier than big houses and that hazard is non captured by market beta.

After publication, the FF theoretical account was tested by a big figure of research workers, and received supported consequences. The size and value premium were confirmed holding important power in explicating the mean stock returns in a figure of stock markets. Chui and Wei ( 1998 ) were the first who test the hardiness of the multifactor theoretical account in Asiatic part. They found that mean stock returns are related to the FF features: house size and book to market equity ratio. Faff ( 2001 ) uses Australian informations from 1991 to 1999 period to prove the power of FF theoretical account and confirmed the explanatory power of the multifactor theoretical account. Additionally, Drew, Naughton and Veeraraghavan ( 2003 ) find that while beta has really weak power, size and BE/ME have strong power in explicating returns. FF theoretical account is confirmed in Shanghai Stock Exchange.

Apart from understandings, FF theoretical account besides received incredulity from legion research workers. ( I ) Kothari, Shanken, and Sloan ( 1995 ) claim that a big portion of the premium is due to survivor prejudice, which means the informations beginning for book to market equity includes a disproportional figure of high BE/ME houses that survive hurt. Therefore the mean return of high BE/ME houses is exaggerated. ( two ) Black ( 1993 ) and MacKinlay ( 1995 ) argue that the hurt premium is merely informations spying, research workers tent to seek for and fixate on variables that are related to mean return, but merely in the sample used to place them. ( three ) Harmonizing to Lakonishok et Al. ( 1994 ) and Haugen ( 1995 ) , is that the hurt premium is existent but unreasonable: the consequence of investor over-reaction that leads to underpricing of hard-pressed stocks and overpricing of growing stocks. ( four ) Another drawback in Fama and Gallic theoretical account is “ January consequence ” , which is foremost documented by Keim ( 1983 ) . The January consequence implies that the monthly returns might hold been consistently higher in January than in other months of the twelvemonth. That consequence might makes the appraisal of beta with monthly returns which are capable to January consequence go really complicated.

Research methodological analysis


The size and book to market variable have important power in explicating the mean stock returns in Sweden stock market. In other words, there is supported grounds for Fama and French three factor theoretical account.

Data aggregation

The stock choice procedure is carried out in a stratified-random manner. 50 non-financial houses will be picked up indiscriminately from a list of common stocks of active corporations in Sweden stock market with a broad diverseness of several pre-determined standards, such as: market capitalisation, dividend payment studies, handiness of net incomes studies. The information includes monthly stock returns, market returns, market capitalisation, book value of stockholders equity and the hazard free rate from January 1998 to December 2008 period. Even though fiscal purchase does n’t hold influence in this research, I determine to extinguish fiscal houses from the sample in order to make a slightly degree of compatibility with FF ‘s research. Firms which have either negative net incomes, negative book equity in any of the months in the period are besides be removed from the sample. This is to do certain that all accounting variables are identifiable, and every observation expresses a significance in a same mode.


Using the same method in Fama and Gallic research ( 1993 ) , I construct portfolios on house size and book to market equity as follow:

Categorization by size:

I use the average size of the whole sample as the breakpoint to set up the difference between two categories. Firm with market equity below the average value of all houses ‘ market equity are allocated in portfolio of little market equity houses and those with values above the average value are put in a portfolio of big market equity houses.

Categorization by book to market equity:

The stocks are classified into three groups of portfolios: one of low book to market equity ( BE/ME ) ratio, one of medium BE/ME ratio and the last being of high BE/ME ratio. The split of the stocks into different classs ( 3 BE/ME group ) was random and Fama and French argued that there was no ground that trial should be sensitive to this pick. Following this statement and given our little sample size, merely two categories of book to market equity ( BE/ME ) value ( low BE/ME and high BE/ME ) will be created. The group of low BE/ME stocks contains stocks whose BE/ME values less than or equal to the average BE/ME and those with greater value of BE/ME ratio than the average BE/ME will be allocated into the high BE/ME stocks group.

The book to market equity ratio is constructed by spliting their book equity value with their market equity value, in which the book equity value of the stocks is the several book value of common stockholder ‘s equity plus the balance sheet deferred revenue enhancement ( if any ) and minus the book value of preferable stocks.

Using this type of categorization, we have four portfolios that are H/S ( high book/small market capitalisation ) , H/B ( high book/big market capitalisation ) , L/S ( low book/small market capitalisation ) and L/B ( low book/ large market capitalisation ) . For our analysis hence, we will utilize 6 portfolios incorporating the four constructed portfolios ( H/S, H/B, L/S, L/B ) and 2 portfolios of high and low BE/ME, which makes a sum of six dependent variables. The leaden monthly returns are so calculated for each portfolio for each month from January to December over the period 1998 to 2008.