UCD Michael Smurfit Business School

EMPIRICAL FINANCE (EF) FIN41330

Assignment 1
Time series Test of Different Asset Pricing Models
Pham, Minh Tung

14200678

Signed

Bui, Thi Huong

14201497

Signed

Lazzoni, Federico

14203143

Signed

Murphy, Niall

14204101

Signed

Statement
We declare that all material included in this project is the end result of our own work and that
due acknowledgement has been given in the bibliography and references to all sources be they
printed, electronic or personal.

Data Description
Table 1: Descriptive Statistics
The table presents the description of the data we use for testing three models: Mean, Median, Standard Deviation (Stdev), Excess Kurtosis (Kurt), Skewness (Skew), Minimum (Min) and Maximum (Max). The data is comprised of stocks from
NYSE, AMEX and NASDAQ. Each of them is assigned into one industry. Using value weighted method, 17 industry portfolios are constructed: Food (Food); Mining and Minerals (Mines); Oil and Petroleum Products (Oil); Textiles, Apparel &
Footwear (Clths); Consumer Durables (Durbl); Chemicals (Chems); Drugs, Soap, Perfumes, Tobacco (Cnsum); Construction and Construction Materials (Cnstr); Steel Works Etc (Steel); Fabricated Products (FabPr); Machinery and Business
Equipment (Machn); Automobiles (Cars); Transportation (Trans); Utilities (Utils); Retail Stores (Rtail); Banks, Insurance Companies; Other Financial (Finan) and Other (Other). The table also contains four risk factors: Market factor (Mkt rf);
Small minus big cap factor (SMB); High minus low (HML) and Momentum factor (Mom). Monthly data is collected in the period of 1/1965 12/2014 and divided into 2 sub-samples: 01/1965 12/1989 and 01/1990 12/2014.

Whole Sample (01/1965 to 12/2014)

First half sample (01/1965 to 12/1989)

Second half sample (01/1990 to 12/2014)

Mean

Median

Stdev

Skew

Kurt

Min

Max

Mean

Median

Stdev

Skew

Kurt

Min

Max

Mean

Median

Stdev

Skew

Kurt

Min

Max

Food

1.09

1.06

4.37

-0.13

2.40

-18.25

20.43

1.21

1.06

4.69

-0.07

2.59

-18.25

20.43

0.97

1.11

4.02

-0.26

1.70

-14.54

15.14

Mines

1.00

0.88

7.43

-0.28

1.65

-32.78

22.46

1.17

0.84

6.82

-0.10

1.82

-31.91

22.18

0.83

0.90

7.99

-0.37

1.38

-32.78

22.46

Oil

1.04

1.13

5.46

0.05

1.32

-18.14

24.06

1.12

1.24

5.60

0.11

1.69

-18.14

24.06

0.97

1.01

5.32

-0.04

0.83

-16.86

19.14

Clths

1.09

1.10

6.28

-0.25

2.39

-31.49

26.73

1.16

1.03

6.34

-0.33

3.08

-31.49

26.73

1.01

1.49

6.22

-0.17

1.65

-22.14

23.27

Durbl

0.80

0.99

5.66

-0.27

2.65

-25.77

29.24

0.86

0.73

5.60

-0.29

1.75

-25.29

20.30

0.75

1.09

5.72

-0.25

3.50

-25.77

29.24

Chems

0.94

0.92

5.66

-0.14

2.39

-27.95

22.30

0.91

0.55

5.60

-0.12

2.51

-27.95

19.93

0.98

1.17

5.72

-0.16

2.27

-21.90

22.30

Cnsum

1.12

1.29

4.60

0.06

2.78

-19.10

29.00

1.15

1.06

4.94

0.22

4.01

-19.10

29.00

1.08

1.38

4.25

-0.21

0.19

-10.05

15.63

Cnstr

1.03

1.06

6.07

-0.11

1.69

-29.19

25.87

0.99

0.80

6.29

-0.06

2.33

-29.19

25.87

1.06

1.30

5.84

-0.17

0.78

-18.62

17.05

Steel

0.75

0.74

7.42

-0.25

2.33

-33.02

30.67

0.75

0.67

6.46

-0.08

1.83

-30.43

21.23

0.75

0.79

8.26

-0.32

2.13

-33.02

30.67

FabPr

0.99

1.22

5.39

-0.51

2.55

-28.62

18.82

1.01

1.07

5.33

-0.52

3.14

-28.62

18.33

0.97

1.47

5.46

-0.51

2.03

-23.03

18.82

Machn

1.01

1.09

6.52

-0.39

1.91

-28.40

19.35

0.88

0.82

5.69

-0.14

1.85

-27.04

17.99

1.14

1.39

7.25

-0.52

1.62

-28.40

19.35

Cars

0.88

0.68

6.38

-0.01

2.25

-28.43

31.74

0.84

0.26

5.97

0.02

1.99

-27.13

22.41

0.91

1.16

6.77

-0.03

2.28

-28.43

31.74

Trans

1.02

1.26

5.73

-0.38

1.50

-28.95

18.06

0.99

1.09

6.42

-0.25

1.16

-28.95

18.06

1.06

1.66

4.94

-0.62

1.44

-17.51

15.64

Utils

0.85

0.92

4.08

-0.10

1.05

-12.65

18.84

0.84

0.46

4.16

0.36

1.24

-12.19

18.84

0.87

1.28

4.01

-0.61

0.82

-12.65

11.72

Rtail

1.02

0.91

5.39

-0.19

2.16

-28.18

26.70

1.05

0.75

5.91

-0.19

2.56

-28.18

26.70

0.99

1.08

4.80

-0.20

0.60

-14.59

15.08

Finan

1.01

1.28

5.51

-0.40

1.70

-22.10

21.12

1.04

0.98

5.37

-0.14

1.13

-21.12

21.12

0.96

1.49

5.64

-0.62

2.13

-22.10

17.07

Other

0.89

1.23

4.86

-0.45

1.46

-22.81

15.32

0.97

1.05

4.72

-0.34

2.05

-22.81

15.32

0.81

1.69

5.01

-0.55

0.96

-17.80

15.29

Mkt-rf

0.49

0.84

4.51

-0.52

1.83

-23.24

16.10

0.36

0.48

4.67

-0.39

2.31

-23.24

16.10

0.63

1.19

4.35

-0.68

1.19

-17.23

11.35

SMB

0.26

0.16

3.14

0.51

5.29

-16.40

22.02

0.34

0.21

2.99

0.12

0.99

-9.90

11.02

0.17

0.05

3.30

0.82

8.13

-16.40

22.02

HML

0.35

0.34

2.89

0.02

2.48

-12.61

13.88

0.48

0.52

2.64

-0.07

1.11

-9.72

8.60

0.23

0.09

3.11

0.10

3.03

-12.61

13.88

Mom

0.69

0.78

4.29

-1.41

10.86

-34.72

18.39

0.83

0.91

3.55

-0.53

2.27

-13.81

15.24

0.56

0.61

4.91

-1.64

11.52

-34.72

18.39

Source: Ken Frenchs site (http://mba.tuck.dartmouth.edu/pages/faculty/ken.french/data_library.html) and Group Estimates

All average portfolio returns and factors are positive, while most of industries have a wide range of
return values and high standard deviation. Nearly two-thirds industry experience a decrease in
average return in the second period. The risk factors have both smaller average return and standard
deviation than the industries do. Besides, the negative skewness in most of the industries and the
factors shows the dominance of the extreme negative return values, the positive excess kurtosis also
indicates the high probability of observing extreme high and low returns.
Can CAPM capture risk-return relationship?
Generally, we did not observe any pattern of the relationship between average excess returns
(known as alpha) and market beta, thus this can be interpreted as the CAPM cannot capture the
relationship between risk and returns of our data sample. The study of Fama and French (1992) and
Theriou et al. (2010) show similar results when testing the CAPM model. The main possible
explanation for this result we suggest is that the unrealistic assumptions under the CAPM. For
instance, the assumption of single-period transaction horizon is unrealistic due to the multi-period
nature of investment. It is also unrealistic if we assume that the CAPM variables remain the same in
successive periods.
Figure 1: Average excess returns versus market beta Whole sample from 01/1965 to 12/2014

Figure 2: Average excess returns versus market

beta sub-sample from 01/1965 to 12/1989

Figure 3: Average excess returns versus market

beta sub-sample from 01/1990 to 12/2014

The explanatory power of SMB, HML and Momentum factor

Table 2: The adjusted-R squared of the regressions of five portfolio returns
The table displays the adjusted-R squared of the regressions of 5 portfolio returns (Food, Mines, Oil, Clths, Durbl) on
individual factors (Market Excess Returns, SMB, HML and Momentum) and also on Fama-French three-factor model
and Carhart four-factor model. Monthly data from 01/1965 to 12/1989 are used to run regression.

Excess
Returns

SMB

HML

Momentum

FF model

Carhart
model

Food

0.5685

0.0108

0.0170

0.0066

0.5901

0.5901

Mines

0.3685

0.1072

0.0126

-0.0005

0.3967

0.3990

Oil

0.4281

0.0016

0.0015

-0.0014

0.4665

0.4756

Clths

0.6205

0.1595

0.0040

0.0657

0.6856

0.7022

Durbl

0.7172

0.1042

0.0244

0.0434

0.7328

0.7402

Source: Group estimates

Fama-French model (FF model) and Carhart model are quite similar in capturing the variations of
the portfolio returns. It is also interesting to note that most of that explanatory power comes from
Market Excess Returns factor. This also means SMB, HML and Momentum factor play minor roles
in explaining the movement of portfolio returns. The maximum capability of SMB is only 15.95%
and even smaller for HML with only 2.44%. Only accounted for 6.57% explanatory power, the
Carhart model still gain excess explanatory power over the FF model due to this additional
Momentum factor. In the scope of this study, we do not cover the significance of that difference.
However, in the study of Bello (2008), the author's test results show that although there is
insignificant difference between these two models, the predictive power of Carhart model is
remarkably improved over the FF model.
GRS test for three models
Whole sample
In two previous parts, we see that although the average excess returns of all assets are not linear
related to their market beta, the SMB and HML factors (taking together) and momentum factor have
small marginal explanatory power. In order to give a more robust conclusion about the three pricing
models explanation in the change in return, we perform GRS test with hypothesis H0: = 0. Early
empirical tests imply that the alpha values are not likely negative. When performing a cross-section
regression of average portfolio return on estimates of portfolio betas, Douglas (1968), Black et al.
(1972), Miller and Scholes (1972), Blume and Friend (1973), Fama and MacBeth (1975), Fama and
French (1992) show that the average value of alpha in this regression is greater than the average

risk-free rate. Thus, we implement a one-tailed hypothesis test, specifically, right-tailed test besides
a two-tailed hypothesis test. The results are as below.
Table 3: GRS test result for 17 industry portfolio returns in the period 01/1965 to 12/2014
The table displays the GRS test results for CAPM, Fama-French three-factor model and Carhart four-factor model for
17 industry portfolio returns defined in Table 1. The data runs monthly from 01/1965 to 12/1965.

CAPM

FF model

Carhart model

GRS statistic

1.7357

3.2605

3.2505

Lower critical value ( = 2.5%)

0.4421

0.4421

0.4421

Upper critical value ( = 2.5%)

1.7992

1.7993

1.7993

Upper critical value ( = 5%)

0.5074

0.5074

0.5073

p-value

0.1456

0.0001

0.0001

Source: Group estimates

As opposed with the right-tailed test, for the two-tailed test, we failed to reject the null hypothesis
H0: = 0 at 95% confident level, therefore CAPM is considered to capture most of the variation in
return. The result is consistent with the time-series regression tests of Friend and Blume (1970),
Black et al. (1972) and Stambaugh (1982) which show that the intercept values are positive for low
beta portfolios and high beta portfolios. It also confirms the previous result we found about the
CAPM. In addition, for the two remaining models, we can reject the null hypothesis at 95%
confident level for both two-tailed and one-tailed test. In other words, Fama-French three-factor
model and Carhart four-factor model do not capture all the movement of average excess return. The
difference between GRS statistics of Fama-French model and Carhart model is quite small. These
results are consistent with the previous findings of the additional explanatory power.
Two sub-samples
We perform the GRS tests for two equal length sub-periods to examine the consistency of the result.
Table 4: GRS test result for 17 industry portfolio returns in two sub-periods
The table displays the GRS test results for CAPM, Fama-French three-factor model and Carhart four-factor model for
17 industry portfolio returns defined in Table 1. The data runs monthly for the first period from 01/1965 to 12/1989 and
the second period from 01/1990 to 12/2014.

CAPM

FF model

Carhart model

1st period

2nd period

1st period

2nd period

1st period

2nd period

GRS statistic

1.7578

1.1023

2.2574

1.7624

2.4318

1.7801

Lower critical value ( = 2.5%)

0.4392

0.4392

0.4392

0.4392

0.4392

0.4392

Upper critical value ( = 2.5%)

1.8241

1.8241

1.8244

1.8244

1.8246

1.8246

Upper critical value ( = 5%)

0.5045

0.5045

0.5045

0.5045

0.5045

0.5045

p-value

0.1403

1.0033

0.0165

0.1521

0.0073

0.1348

Source: Group estimates

In the first period, for the right-tailed hypothesis test, the intercept estimates of all three assetpricing models jointly are different from zero at 5% significance level, while in the second one, we
failed to reject the null hypothesis for CAPM only. We can conclude that in the second period,
CAPM can explain most the variations in portfolio return.
All GRS statistics in the second period are lower than the ones in the first period, which shows that
the asset pricing models explain the change in return in the first period better than in the second
one. Moreover, the GRS statistics of CAPM in both periods are smaller than the two remaining
asset-pricing models. This results contrast with the conclusion of Fama and French test (1996) using
the period 01/1963 to 12/1993 and Connor and Senghal (2001) which show the superiority of the
three-factor model. The disparities between the tests or the periods may be explained by the
efficiency of market proxy, the unrealistic assumptions of CAPM and the difference of market in
different test period.
Conclusion
Generally, the results we found show that the CAPM failed to capture the risk-return relationship.
The explanatory power of SMB, HML and Momentum factor is trivial in explaining the variations
in portfolio returns for the data set of 17 Industries Portfolio returns in the period of 01/1965
12/2014. The GRS test results also confirm this result since the alphas from all three models are
significantly different from zero.
References
BELLO, Z. Y. 2008. A Statistical Comparison of the CAPM to the Fama-French Three Factor
Model and the Carhart's Model. Global Journal of Finance and Banking Issues, 2.
FAMA, E. F. 1996. Multifactor portfolio efficiency and multifactor asset pricing. Journal of
Financial and Quantitative Analysis, 31, 441-465.
FAMA, E. F. & FRENCH, K. R. 1992. The crosssection of expected stock returns. the Journal of
Finance, 47, 427-465.
FAMA, E. F. & FRENCH, K. R. 2004. The capital asset pricing model: Theory and evidence.
Journal of Economic Perspectives, 18, 25-46.
JENSEN, M. C., BLACK, F. & SCHOLES, M. S. 1972. The capital asset pricing model: Some
empirical tests.