Validity Of The Fama French Three Factor Model

Week 1 – Introduction – Financial Accounting (Review) Week 2 – Financial Markets and Net Present Value Week 3 – Present Value Concepts Week 4 – Bond Valuation and Term Structure Theory Week 5 – Valuation of Stocks Week 6 – Risk and Return – Problem Set #1 Due Week 7* – Midterm (Tuesday*) Week 8 - Portfolio Theory Week 9 – Capital Asset Pricing Model Week 10 – Arbitrage Pricing Theory Week 11 – Operation and Efficiency of Capital Markets Week 12 – Course Review – Problem Set #2 Due

In this literate review the most important papers about explaining stock returns from 1952, when Markowitz came up with Modern Portfolio Theory, till around 2011 will be discussed. As stated in Chapter 2, Jack Treynor was one of the first economists that started to work on the CAPM model. When he developed the CAPM in 1961, there was no way yet to fully test it. Because there were no samples large enough or of sufficient quality, the real testing of the CAPM started in 1970. In 1973, the world was shown the famous Black and Scholes options pricing model. One of the first studies that gave a different answer than the CAPM was the research by Basu (1977). While he agrees with the Efficient Market Hypothesis, Basu reaches another

‘The Capital asset pricing model (CAPM) is a very useful model and it is used widely in the industry even though it is based on very strong assumptions. Discuss in the light of recent developments in the area.’

In order to test the validity of the CAPM, we have applied the two-step testing procedure for asset pricing model as proposed by Fama and Macbeth (1973) in their seminal paper.

Fama and French employ the one month NYSE stocks between 1926 and 1885 from the CRSP database. They rebalance ten decile portfolios based on the market value, price per share times share outstanding. One-month equal weighted portfolio returns are calculated and compounded continuously. The nominal returns ae adjusted by the CPI, and then summed on long rum returns. The estimation method for the regressions of r(t, t+T) on r(t-T, t) is the OLS.

The analysis of this paper will derive the validity of the Fama and French (FF) model and the efficiency of the Capital Asset Pricing Model (CAPM). The comparison of the Fama and French Model and CAPM (Sharpe, 1964 & Lintner, 1965) uses real time data of stock market to practise its efficacy. The implication of the function in realistic conditions would justify the utility of the CAPM theory. The theory suggests that the expected return demanded by investors on a risky asset depends on the risk-free rate of interest, the expected return on the market portfolio, the variance of the return on the market portfolio, and

The United States and China are the world's largest investor and utmost contributor to global financial and economic growth by wide margins. The competence of its financial system in allotting capital to asset will be significant to sustain this growth. This paper examines the comparative relations of US and Chinese stock market from the 1980s to the global financial crisis of 2008 and the relative impact of Chinese markets on the US stock markets as China opens up to investors globally. China's stock market since the last financial reform has become as educational about forthcoming corporate profits as in the US. Furthermore, although it is a closed market meaning not everyone can have the opportunity to invest in Chinese markets, Chinese

Many extensive studies have been conducted on the behavior of stock prices, which has provided a numerous number of theories that propose how prices will change given certain circumstances. The most fundamental theory on the behavior of the stock market was published in 1970 by Eugene F. Fama in his research, titled Efficient Capital Markets: A Review of Theory and Empirical Work. The theory he proposed is referred to as the Efficient Market Hypothesis (EHM) and is considered to be one of the most classical and resilient economic theories. In his work he proposes the securities markets are extremely efficient in a way that information about individual stock prices is reflected across the market so quickly that an investor cannot beat the market, meaning a portfolio comprised of similar risk stocks will generate comparable profits. Furthermore, this theory suggests that stock prices are entirely unpredictable, such that the only relevant information on what the price of a specific stock will be tomorrow is the news that occurs that given day.

Since Fama-French Three Factor Model seem to explain average returns on stocks and bonds of North American publicly traded companies (Fama et al., 1993). But no test has been performed on the firm-level returns. Therefore, we present the following hypotheses formally here:

Another significant study of multifactor models is suggested by Fama and French (1992). They explore the validity of CAPM by using beta, size or market value of equity, and book to market equity, price earning and leverage as an explanatory variables. The joint roles of these variables are explored average security’s returns by using cross section analysis. The main results of this study is that variation in returns might not be explained by beta because there is little explanation about mean

Moreover, there are some cross-sectional predictable patterns, such as ¡®Value Stocks appear to provide higher rates of return than stocks with high price-to-earnings ratios¡¯ when accepting CAPM, Malkiel argues that the finding does not necessarily imply inefficiency of the financial market, it may only indicate failure of the CAPM to capture all dimensions of risk.

Given the above drawbacks, this dissertation will try to build a model using the latest data and the more appropriate model to evaluate the existing impact of selected macroeconomic effects on stock market indexes in China. By using the VAR (vector autoregression) model, the cointegration test, and the Granger causality test, this paper aims to give some helpful information on developing countries, especially China, to the investors for hedge or speculation. At the same time, it provides some possible policy suggestions on macroeconomy and stock markets to the Chinese governments for better development in the future.

The idea of investing in the stock market is at times challenging. Heightened activities witness the stock market itself. These activities gained the investor’s interest increasingly. The stock market patterns have changed due to the current globalization and integration of the subsequent markets. Just to name some of the global markets are New York Stock Market, Hong Kong Stock exchange among others. Sometimes these market patterns have changed due to politico-economic backgrounds (Hamid Faruqee, 2008, p. 154).

As the size of middle class rose significantly from 1980s to 2000s in China, accumulation of more wealth stimulates the growth of investment in the stock market. So far, in China there are more than two hundred million trading accounts and most of them began investing in the stock market after seeing the bull market in 2014 as demonstrated in Figure I. However, the Chinese stock market operates differently from U.S. and European markets, for which it is driven heavily by speculation rather than long term investment.

Ferson and Harvey (1999) queried the performance of FF three factor model under different conditions and raised dynamic factor pricing model (DFPM). Carhart proposed the four factors model including the momentum factor in 1997. Griffin (2002) separated and studied usefulness of country-specific and international component of FF three-factor model and found country-specific versions are more useful at explaining time series variation in portfolios. Even though used to be the constructive break-through at that moment, their findings were made from obsolete data. In this paper. I explore the empirical results of recent literatures to re-examine if size factor is still well performed in current broader markets.