The document discusses multi-factor models of risk and returns, including the Fama-French model. It explains that Fama and French identified small firm size and high book-to-market ratios as factors influencing stock returns. It outlines the steps to calculate size premium, book-to-market premium, and develop a multi-factor model like Fama-French to predict stock returns based on sensitivity to various risk factors. The document also briefly mentions the arbitrage pricing theory and alternative macroeconomic factors that can be used in multi-factor models.
The document discusses multi-factor models of risk and returns, including the Fama-French model. It explains that Fama and French identified small firm size and high book-to-market ratios as factors influencing stock returns. It outlines the steps to calculate size premium, book-to-market premium, and develop a multi-factor model like Fama-French to predict stock returns based on sensitivity to various risk factors. The document also briefly mentions the arbitrage pricing theory and alternative macroeconomic factors that can be used in multi-factor models.
The document discusses multi-factor models of risk and returns, including the Fama-French model. It explains that Fama and French identified small firm size and high book-to-market ratios as factors influencing stock returns. It outlines the steps to calculate size premium, book-to-market premium, and develop a multi-factor model like Fama-French to predict stock returns based on sensitivity to various risk factors. The document also briefly mentions the arbitrage pricing theory and alternative macroeconomic factors that can be used in multi-factor models.
CAPM and The Real World A theory or a model is considered good if it can predict real world better CAPM was first introduced in 1964 Early tests by Black, Jensen and Scholes (1972) partially supported the CAPM They found that average returns were higher on stocks with higher beta CAPM and The Real World (Con’t) However, Ross (1977) presented a paper “A critique of capital asset pricing tests” in which he heavily criticized CAPM Ross argued that since the market portfolio can never be observed, the CAPM is unstable. Arbitrage pricing theory(APT) Ross in the mid-1970s arbitrage pricing theory (APT). The main difference between the CAPM and the APT is that the latter specifies several risk factors, thereby allowing for a more expansive definition of systematic investment risk than that implied by the CAPM’s single market portfolio Practical problem in APT implementation Despite several appealing features, one of the practical challenges that an investor faces when attempting to implement the APT is that the risk factors in the model are not defined in terms of their quantity (i.e., how many there are) or their identity (i.e., what they are). E (R i ) = l0 + b1l1 + b 2 l2 + b k lk l0 = RFR l = RISKPREMIUM b1 = SENSITIVITY Macro and Micro risk factors Risk factors may be : Micro risk factors (Fama and French) Macro risk factors ( Inflation, interest rate, etc) FAMA and French Model FAMA and French presented three factor model and showed that their model can predict security returns better than CAPM Fama and French (1996) collected data on those firms that provided above average return Then they tried to find out the common features among these firms They observed that historically average returns are high on: Stocks of small firms Stocks of firms with high B/M ratio FAMA and French Model (Con’t) The above two may be proxies for exposure to systematic risk that is not captured by CAPM i.e. Small stocks may be more sensitive to changes in business conditions ( macro-economic factors) And firms with high B/M ratio are more likely to be in financial distress These variables capture sensitivity to macro economic risk factors Stocks with the above two features will be more risky, and the required rate of return should be higher on them (RRR) =Rf+ B1(Rm-Rf) + B2(RSMB) +B3(RHML) + eFFC How to make the model operational The following steps are followed: Calculate the size premuim over a period of time Calculate the B/M ratio preuim Calculate risk premuim on market protfolio Calculate returns for a given stock ( e.g FFC etc) and then put these value in: (Rffc –Rf) =Rf+ B1(Rm-Rf) + B2(RSMB) +B3(RHML) + eFFC Size premium The size premium is the historical tendency for the stocks of firms with smaller market capitalizations to outperform the stocks of firms with larger market capitalizations. It is one of the factors in the Fama–French three- factor model Size Premium(SMB) 1. First sort firms by size Size can be measured by the market capitalization, or assets of the firm Calculate the monthly rate of returns on the largest firms and find the average return Calculate the monthly rate of returns on the smallest firms and find average return Calculate the monthly difference between the average returns of the largest and smallest firms Value Premium(HML) What Is the Book-to-Market Ratio? The book-to-market ratio is used to find a company's value by comparing its book value to its market value. Value Premium (HML) If the market value of a company is trading higher than its book value per share, it is considered to be overvalued. If the book value is higher than the market value, analysts consider the company to be undervalued. Value Premium (HML) Specifically, HML shows whether a manager is relying on the value premium by investing in stocks with high book-to- market ratios to earn an abnormal return. If the manager is buying only value stocks, the model regression shows a positive relation to the HML factor, which explains that the portfolios returns are accredited only to the value premium. Value Premium (HML) Obtain the Book for your UNIVERSE companies for your assigned year Calculate the market value Calculate B/M ratio = Book value / Market capitalization Place the B/M ratio values in columns next to the UNIVERSE companies Sort the UNIVERSE companies from HIGH to LOW B/M ratio by using the A Z function of MS-Excel on the B/M ratio
Value Premium (HML) Select the top 5 companies and name this group of 5 companies as HIGH Select the bottom 5 companies and name this group as LOW companies Obtain monthly (end-of-month) closing share prices for 12 months for the HIGH companies Calculate monthly returns for each company in the HIGH group Value Premium (HML) Calculate average return for the HIGH in each month by averaging the returns of the 5 companies Repeat the same process for LOW group to calculate average monthly return Subtract the average returns of LOW from the average returns of HIGH in each of the 12 months. These monthly differences are your HML Calculating return on large firms Calculating return on small firms Size Premium Calculating B/M Premium Stocks with LOW B/M High B/M stocks HML Final Variables Dependent variable = FFC excess return Results Interpretation 1.51(Rm – Rf) = Means if excess return on market portfolio increases, there will be 1.51 times increase in the excess returns of FFC stock 1.35 (SMB) = Means that if the difference in returns of small and big firms increases, there will be 1.35 increase in the returns of FFC -1.71 (HMB) = measn that if difference in returns of firms with high and low B/M ratio increases, there will be 1.71 decrease in the returns of FFC Now the Required Rate of return Rf +B(Rm-Rf)+B(SMB)+B(HML) Annual Rf = 13%, Annual Rm = 27% Annual SMB= 21.%, Annual HML = 29% 13%+1.51(27-13)+1.35(21.2)-1.71(29) 13%+ 20.38+ 28.62 - 49.59 12.41% Based on the systematic risk of FFC, investor will required 12.41% return FCC stock Multi – Factor Models The alternative to the Fama-French approach is to select macro factor that may be proxies for systematic risk that affect firms returns A research study conducted by Chen, Roll, and Ross (1986) used extensive list of various systematic factors affecting returns Like….. Change in industrial production Change in expected inflation Interest rate spread on long term Short term bonds Unanticipated inflation excess return of long term corporate bonds over long term govt bonds etc.