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CHAPTER I

INTRODUCTION

1.1 Background

Theories of pricing model have been developed for years by many academicians.

Each of those pricing model has different variables, considerations, and factors to be put into

the models developed. Those pricing models have been used by academicians and

practitioners in explaining, assesing, and defining the expected returns that assets can have in

relevant with the risk that investors should consider when they want to conduct investments

activities.

The first model to be developed to explain returns of assets (especially stocks) is

Capital Asset Pricing Model (known as CAPM), developed by Sharpe (1964), Lintner (1965),

and Mossin (1966). This model is widely use because of its simplicity. After Capital Asset

Pricing Model was being developed to explain asset return (usually stocks), many asset

pricing models come up with different approaches to advance the explanation of expected

assets return in relevant with different risk proxies that investors should consider when

making a decissionabout investment activities. From those many assets pricing model, some

of them are, Inter-temporal Capital Asset Pricing Model, developed by Merton (1973), The

Arbitrage Pricing Model developed by Chen and Ross (1986), and Three factor model

developed by Fama and French (1993).

Different variables are being used by those pricing models to explain assets (stocks)

return. Many researches and journals, compared two of them which are, the Capital Asset

Pricing Model and Three Factor Model. The main reason is that, those two pricing models are

generally applicable in different stock market circumstances across countries in the world,

and in any economic conditions and characteristics that attached to a country being examined

in the research.
The well-known prediction of CAPM is that, the expected excess return on an asset

equals the beta of the asset times the expected excess return on the market portfolio, where

the beta is the covariance of the assets’ return with the return on the market portfolio divided

by the variance of the market return. John (2007) explained the simplicity of CAPM in

explaining expected return on an asset. He explained that the expected rate of return on an

asset is a function of the two components of required rate of return-the risk free rate and the

risk premium. Thus,

Ki = Risk-free rate + Risk Premium

= RF + β [E(RM) – RF]

Equation 1.1

The use of only one risk factor in explaining expected return, makes this pricing

model also being known as single factor model. Dhamodaran (2001) also explained CAPM

with an analogy of an asset. He explained that in CAPM world, where all investors hold

market portfolio, the risk to an investors’ individual asset will be the risk that this asset adds

to the market portfolio. Intuitively, if an asset move independently in relevant with market

portfolio, it will not add mcuh risk to the market portfolio. In other words, most of the risk in

this asset is firm-specific and can be diversified. In contrast, if an asset tends to move up

when the market portfolio moves up, and move down when market portfolio moves down, it

will add risk to the market portfolio. It implies that this asset has more market risk and less-

firm specific risk. Statistically, this added risk is measured by the covariance of the asset with

market portfolio.

Under CAPM, investors adjust their risk preferences by using their allocation

decission, whther they want to invest more in riskless assets or more in market portfolio.
Investors who are risk averse will choose to put more or even all their wealth to riskless

assets. Conversely, investors who are risk taker will invest more, or even all of their wealth in

market portfolio. Investors who invest their wealth in market portfolio and desired to bear

more risk, would do so by borrowing at the riskless rate and investing in the market portfolio

as anyone else.

However some researches argue that the market beta itself is not sufficient to explain

expected stock return. As quoted by Fama and French (1992); Basu (1977), shows that when

common stocks are sorted on earning price ratio (E/P), future return of high E/P stock are

higher than those predicted by CAPM. Moreover, Banz (1981), documented size effect, which

revealed the statistical fact that stocks with low market value (market capitalization), earned

higher return than what is predicted by CAPM; stocks with low market value have higher

beta and higher average returns than those stocks with higher market value, but the difference

is higher than those predicted by CAPM. Fama and French (1992), study the joint roles of

market β, size, E/P, leverage, and book to market equity in the cross section of average stock

return. They find that used alone, or in combination with other variables, β (the slope in the

regression of a stock’s return on a market return) has little information about average return.

Used alone, size, E/P, leverage, and book-to-market equity seem to absorb the apparent roles

of leverage and E/P in average return. Briefly, their research resulted in the statistical

conclusion that, two empirically determined variables, size and book-to-market equity, do a

good job in explaining the average returns.

Thus, concerning other factors that might be able to explain stocks return, Fama and

French (1993) developed a model called three factors model. This model is not only using the

return of market portfolio to explain expected return, but also the other two factors, which are

size and book-to market ratio. Mathematically, the model can be written as follow:

E(Ri) - Rf =c + βi (E(RM) – Rf) + si E(SMB) + hi E(HML) +e


Fama and French three factors model captures the performance of stock portfolios

grouped on size and the book-to-market ratio. Fama and French (1993,1996), have

interpreted that their three factors model as evidence of risk premium or "distress premium”.

Small Stocks with high book-to-market ratios are firms that have performed poorly and are

vulnerable to financial distress, and investors recognized a risk premium for this reason.

Using the monthly stocks return data in NYSE, AMEX, and NASDAQ, from 1963 to

1991, Fama and French (1993) started their analysis by sorting stocks based on their size and

their book-to-market ratio. They break the stocks based on size, into two groups, those stocks

with small capitalization, and those stocks with big capitalization. Individually, they also

break the stocks to be observed based on their book-to-market ratio, based on the breakpoints

into three groups, those with low book-to-market ratio (30% of stocks), those with medium

book-to-market ratio (40%), and those with high book-to-market ratio (30%). Their decision

to break stocks into three groups on book-to-market ratio and only two groups on book-to-

market ratio, is based on their previous findings in Fama and French (1992), revealed that

book-to-market equity has stronger role in average stock returns than size. Then six portfolios

are formed based on the interception of the two size groups and the three book-to-market

group, they are S/L, S/M, S/H, B/L, B/M, B/H (i.e S/L is portfolio consist of those stocks

with small capitalization and low book-to-market ratio). The returns of those six portfolios

are then being used as dependent variables.

They use the excess market return (E(RM) – Rf), which is the difference between the

return on market portfolio, with risk free rate, as proxy for the market factor in stock return.

To capture the size effect, they use the return of portfolio named under SMB (Small

Minus Big). SMB meant to mimic risk factor in returns related to size. It is the difference

(each month) between the simple averages of the return of the three small-stock portfolios

(S/L, S/M, and S/H) and the simple average returns of three big-stock portfolios (B/L, B/M,
B/H). Thus, SMB is the difference between the returns on small and big stock portfolios with

about the same weighted average book-to-market equity.

To mimic capture the risk factor in returns related to book-to-market ratio, they use

the return of portfolio named under HML (High Minus Low). It is the difference, each month,

between the simple average of the returns on the two high book-to-market portfolios (S/H and

B/H) with the simple average returns on the two low book-to-market portfolios (S/L and

B/L). The two components are return on high and low book to market portfolio with about

the same weighted average size.

But, there also many research doubt about the strong relationship between book-to-

market ratio, and size toward return. Kothari, Shanken, and Sloan (1995), as quoted by Fama

and French (1996), found that the relationship between book-to-market ratios toward return is

relatively weak and not consistent with the findings of Fama and French (1992). The

relationship between book-to-market ratio and return were partly caused by a certain bias on

data. Bias on the data happened when there are data that cannot be obtain because the firms

did not publish its financial reports, or the data from previous period are being used to fill the

missing data that happen in the current period.

There are also many explanations about size and book-to-market anomalies.

Lakonishok, Shleifer, and Vishny (1994), Haugen (1995), and McKinlay (1995) , as quoted

by Fama and French (1996), argue that the premium of financial distress is irrational. Three

arguments justify it. First, it can express an over-reaction of the investors. Second argument

is relative to the empirical observation of low stock return of firms with distress financial

situation, but not necessarily during period of low rate of growth of GNP or of low returns of

all stocks in the market. Lastly, diversified portfolios of stocks with, as well high as low,

book-to-market ratio; have the same variance of return


From the discussion above it can be implied that the research about stock return and

pricing model is worth to be reviewed, mainly in emerging market stock exchange. The new

findings of Fama and French becomes an identification of risk factors that explain the

statement and phenomenon that return is the trade-off between risk and return. This research

is an empirical research about models that theoretically and empirically are commonly used

to explain stock return. The consideration of using those two pricing model in the research is

that, although both pricing model has different approach in assessing expected return, they

actually have similarities. Both of the models are using market premiums as one of the

variable. The use of market premium will be able to capture risk regarding market factor.

This market factor will be able to capture the non-diversifiable risk, or risk that cannot be

diversified by using portfolio. Hence, Indonesian Stock Market risk premium can be traced

down and being put into consideration in the analysis to recognize the non-diversifiable risk

which exist in the market .

As Indonesian Stock exchange is considered as young Stock market (established in

1985). The use of both pricing model will be beneficial to reveals, whether the factors that are

proposed by these two pricing models are applicable, robust, and reliable enough to be used

as consideration and justification regarding the expected return that investors willing to get

by investing on equity market.

Thus, to serve the aim, this research will hopefully discuss deeply and

comprehensively about “The factors Affecting Portfolio Return in Indonesia Stock

Exchange : Fama three Factors model vs Capital Asset Pricing Model”

1.2 PROBLEM STATEMENT

Based on issues discussed in the background, the problem statements of this research

are stated as follows:


1. Does market factor positively affecting stocks portfolio consist of stocks listed in

Indonesian stock market.

2. Does the difference between the return of stocks portfolio consist of small-sized firm

and big sized firm (SMB), affecting positively toward the return of portfolio consist

of small size firms.

3. Does the difference between those firms included in high book to market ratio and

those firms included in low book to market ratio, affecting the return of equity

portfolio positively.

4. Which one of those pricing models (CAPM or Fama and French Three factor model)

can explain stock returns better, especially under Indonesian stock market return.

1.3 LIMITATION OF THE RESEARCH

This research is being conducted by observing the monthly changes of individual

stock price that are listed in Indonesian stock exchange, the changes of Indonesian

Composite Index (IHSG). Stocks that are included in this research are only the stocks of

non-financial firms, from 2007-2010

1. This research will compare the robustness of fama and French three factor models

with CAPM, in terms of its slopes and coefficients, and to test the significance of

market factor, SMB and HML factor.

2. Data that are being used are the data of non-financial firms that are listed in

Indonesian stocks exchange from 2007-2010, with no missing observation, and

the stock should not have minus book to market ratio during the time period of the

research.

3. Both CAPM and Fama and French Three factors are model designed to calculate

expected return. This model cannot be tested because expectation is an


unobservable value. Those that can be observed and then can be tested is historical

value (ex post). Hence for the two pricing models are able to be tested, all data

that are being used are historical data, and the empirical model will change the

expected notion (e.g E(r)) to historical return ( R ).

1.4 PURPOSE OF THE RESEARCH

This research is aim to:

1. Which one of those two pricing theories describes the factors affecting equity price

more effectively?

2. Test whether the market factor affecting stocks return at Indonesian stock market

3. Test whether the difference between the return of small sized firms and big sized

firms (SMB) positively affecting the return of portfolio consisted of small sized firms.

4. Test whether the difference between the return high book to market ratio firms and the

return of low book to market ratio firms (HML), positively affecting the return of

portfolio consist of stocks that are listed in Indonesian stocks exchange.


CHAPTER II

THEORIES AND HYPOTHESIS DEVELOPMENT

2.1 The concept of risk and return

Every investor invests their money in a particular asset with the expectation that their

wealth will grow for some defined future period. The gain that the investors have by

investing their wealth in some particular assets for some defined future period is called

return.

John (2007) differentiates between two kinds of return, which are expected return and

realized return. Expected return is defined as the anticipated return expected by investors

over some future holding period, while Realized return is defined as actual return on an

investment for some previous period of time.

There are two components of return as explained by Jones (2007).

1. Capital gain (loss): it measures the appreciation or depreciation in the price of the

asset, or simply addressed as the price change. In the case of long position, it is the

difference between the purchase price and the price at which the asset can be, or, is

sold; for the case of short position, it is the difference between the sale price and the

subsequent price at which the short position is closed out. In either case, gain or loss

can occur.

2. Yield : it measures the periodic cash-flows (or income) on the investment either in

terms of interest or dividend.

Risk, defined in statistical terms as the variance in actual returns around expected

returns (Dhamodaran,2001). The greater is the variance, the more risky is the asset.

Commonly, considering portfolio construction, investors decomposed risk related into two

types of risks: diversifiable and non-diversifiable risk.


Diversifiable risk as defined by Brigham and Houston (2007), is that part of a

security’s risk associated with random events that can be eliminated by proper diversification,

usually called firm-specific risk (risk that attach to a specific firm); while non-diversifiable

risk defined as that part of a security’s risk that cannot be eliminated by diversification,

usually addressed as market risk (e.g interest rate, war, inflation, ect).

The rule of thumb that usually being used by investors is that, they want to get

compensated by bearing more risk in their investment activities. Thus, the higher the risk, the

higher the expected return

2.2 Capital Asset Pricing Model

Capital Asset Pricing Model (CAPM), was developed by William Sharpe (1964),

John Lintner (1965) and Jan Mossin (1966), independently. Brigham and Ehrhardt (2005) as

quoted by Nophbanon et al (2009) , stated that, this pricing theory was developed based on

these assumptions

• All investors focus on a single holding period, and seek to maximize the expected

utility of their terminal wealth.

• All investors can borrow or lend an unlimited amount at a given risk-free rate of

interest.

• Investors have homogenous expectation

• All assets are perfectly divisible and perfectly liquid

• There are no transaction cost

• There are no taxes

• All investors are price takers

• The quantities of all assets are given and fixed


By holding those assumptions above, it allows investors to keep diversifying without

additional cost. Dhamodaran (2001) argued that, at the limit, their portfolios will not only

include every traded assets in the market but also will have identical weights on risky

assets (based on their market value).

With that explanation above then it can be implied that at the limit, all investors in the

world of CAPM will formed a market portfolio, that is, a portfolio that consist of all

assets that are available in the market place.

Considering the market portfolio, the concept of CAPM can easily be explained using

Security Market Line (SML).

E(Ri)

E(RM) Security Market Line


M

RBR

Beta
0 1.0

Fig 2.1

Beta determined the value of additional expected return for individual security with

the argument that portfolio that is perfectly diversified the non-systematic risk (diversifiable

risk) tend to disappear, and left Beta measuring systematic risk (non-diversifiable risk) as the

only relevant risk to be considered in the model. This argument is based on assumption that
for homogenous expectation, all investors will formed a market portfolio that is perfectly

diversified, thus the only relevant risk for every securities is measure by Beta

In figure 2.1, point M, representing a market portfolio with Beta equals 1.0 and

expected return as big as E(RM). For riskless asset with 0 Beta, the expected return is R BR

which is the interception between the Security Market Line and E(R i). Assuming that

Security Market Line is linier, thus the equation of this linier line can be expressed as the

intercept with the value of RBR and the slope will have the value of [E(RM) - RBR] / βM.

Because βM = 1, thus the slope of Security Market Line will have the value of [E(R M) - RBR].

Thus the equation for ith securities can be written as:

E(Ri) = RBR + βi . [E(RM) - RBR]

Equation 2.1

Equation 2.1 is the equation that being recognized as Capital Asset Pricing Model.

With that equation, the expected return of an equation can be determined.

Jogiyanto (2007) explained that if Beta for market portfolio is equal one, thus for

those securities with Beta less than one will have less systematic risk, and will be expected to

have return less than the market return. Conversely, those securities with Beta more than 1

will have bigger systematic risk, and will be expected to generate return more than the market

portfolio does.

The model in equation 2.1, is the model to calculate expected return and cannot be

tested for the sake of this research, because ex-ante return is not observable and obviously the

data is not available. Thus this research will use ex-post return, and change the CAPM

equation to:
Rit = RBRt + βi . [RMt - RBRt]

Equation 2.2

Equation 2.2 is the ex-post model of CAPM, which recognize the use of historical

data. (Jogiyanto, 2007).

2.3 The relationship between stock return and firms’ characteristics

2.3.1 Firm’s size

The relationship between stock return and size is still debatable. There are several

researches that tried to examine the relationship between firm’s sizes (represented by market

capitalizations) with stock return. Banz (1981) and Reinganum (1981) were among the first to

examine the relationship between size and stock return. They found that firm size or

capitalization, measured as the market value of equity, possess significant influence on stock

returns, smaller size firm, earn higher return than the bigger size firm.

Banz (1981), concluded in his research considering size effect, that on average, small

NYSE firms had significantly larger risk adjusted returns, than large NYSE firms over a forty

year period (his study used time period from 1931-1975). However, they stated that this size

effect is not linear in the market proportion, but is most affected the smallest firms in the

sample. He also admitted that there is no theoretical foundation for size effect. The research

conducted did not specified the fact whether the factor is the size itself or it’s just the proxy

for one or more true but unknown factors correlated with size. Reinganum (1980) as noted by

Banz (1981), has eliminated one possible candidate for the unknown factor, which is P/E

ratio. He reported that P/E effect disappears for both NYSE and AMEX stocks when he

controls for size, but there is a significant size-effect when he controls for P/E ratio, thus it
proves that P/E effect is the proxy of size effect and not vice versa. Stattman (1980) as noted

by Banz (1981), also eliminated one of the possible candidate which is book to market ratio.

Banz (1981) refers to Klaim and Bawa (1977) as one of the most possible explanation

that can justify the relationship between size and stock return. They find that if insufficient

information is available for a subset of securities, investors will not hold these securities

because of estimation risk, i.e because of the uncertainty about the true parameters that

justifies return distribution. If investors differ in the amount of information available, they

will limit their diversification to different subsets of all securities in the market. It is likely the

amount of information generated, is related to the size of the firm. Therefore many investors

would not desire to hold the common stock of very small firms. Thus, lack information about

small firms leads to limited diversification and therefore for higher returns for “undesirable”

stocks of small firms. Since this informal logic resulted in the same logic as with the

empirical test, he argued that it was just a coincidences or conjecture.

In the continuance of those findings above, Fama and French (1992) observed that firm

size capture much of the cross-sectional empirical relation with average stock return. Fama

and French (1993) showed that size proxy for sensitivity to risk factor that capture strong

common variation in stock return and help explain the cross-section of stock-return. However

size remain arbitrary indicator variable related to risk factor in explaining average return due

to unexplained economic reason. Thus, Fama and French (1995) conducted a research to

clarify this issue, and they found that size factor in fundamentals, (earning and sales), is

similar to those in stock returns, which lead to the strong presumption that the common factor

in fundamentals, drive the risk factors in returns. Thus the evidence show that size is related

to profitability.
2.3.2 Firms’ Book-to-Market ratio

Stattman (1980) and Rossenberg, Reid and Leinstein (1985) as noted by Fama and

French (1992) find that average returns on U.S stocks are positively correlated with book-to-

market ratio. Chan, Hamao and Lakonishok (1991), as quoted by Fama and French (1992)

also find that book-to market ratio has a strong role in explaining the cross-section of average

returns on Japanese Stocks. Fama and French (1992) noted that it is possible that the risk

captured by book-to-market ratio is the relative distress factor of Chen and Chan (1991).

They stated that the earnings prospects of firms are associated with a risk factor in return.

Firms that the market judges to have poor prospects, signaled by low stock price and high

book-to-market ratio, have higher expected return (they are penalized with higher cost of

capital) than firms with strong prospects.

In Fama and French (1992) they documented that book-to-market ratio is related to

economic fundamentals. Firms that have high B/M ratio (a low stock price relative to book

value) tend to have low earnings on assets and the low earnings persist at least five years

before and five years after the B/M ratio is calculated. Conversely those firms with high B/M

ratio (a high stock price relative to book value) are associated with persistently high earnings.

Auret and Sinclair (2006), tried to explain the logic behind the recognition of book-to-

market ratio as risk factor. The book value of the firm is the difference between total assets

(resources expected to results in inflows economic benefits) and liabilities (obligation

expected to result in outflows of economic benefit), or a measure of net expected inflows of

economic benefits, or earnings. However, there is inherent uncertainty surroundings those

earnings. Investment in two firms, each with similar book value to the other, are likely to be

valued differently, if there is more uncertainty surrounding the return of one versus another.

The investment with lesser uncertainty (less risk) is likely to be preferred, to the investment

with grater uncertainty (higher risk), since the marginal utility of risk is assumed to be always
negative, as mentioned by Markowitz (1956). As a result, the market value of the less risky

investment is likely to be higher than the market value of the more risky investment. Since

book-to-market ratio is the ratio of the book value and the market value of the firm, the less

risky investment is therefore likely to have lower book-to-market ratio than a more risky

investment. Given that higher returns are necessary to induce investors to purchase a riskier

investment, a positive relationship between book-to-market ratio and returns emerged.

2.4 Fama and French three factors model

Several of the return anomalies in CAPM were being affiliated by three factor model

(Fama and French, 1993). This model stated that excess return of a portfolio [E(Ri) - Rf], can

be explained by return sensitivity toward three factors, they are: excess return of market

portfolio [E(RM) – Rf], the difference between the average return of portfolio consist of stock

with small capitalization, with those who have big capitalization (SMB), and the difference

between the average returns of portfolio consist of stocks with high book-to-market ratio,

with those stocks with low book-to-market ratio (HML). Those variables can be expressed

as following equation.

E(Ri) - Rf =c + βi (E(RM) – Rf) + si E(SMB) + hi E(HML) +e

Equation 2.3

Where E(RM), E(SMB), and E(HML) are expected premiums; βi , si , and hi are factors

sensitivity, which represent the slope of time-series regression. As stated previously in the

background, the details of their research are as follows.

Using the monthly stocks return data in NYSE, AMEX, and NASDAQ, from 1963 to

1991, Fama and French (1993) started their analysis by sorting stocks based on their size and
their book-to-market ratio. They break the stocks based on size, into two groups, those stocks

with small capitalization, and those stocks with big capitalization. Individually, they also

break the stocks to be observed based on their book-to-market ratio, based on the breakpoints

into three groups, those with low book-to-market ratio (30% of stocks), those with medium

book-to-market ratio (40%), and those with high book-to-market ratio (30%). Their decision

to break stocks into three groups on book-to-market ratio and only two groups on book-to-

market ratio, is based on their previous findings in Fama and French (1992), revealed that

book-to-market equity has stronger role in average stock returns than size. Then six portfolios

are formed based on the interception of the two size groups and the three book-to-market

group, they are S/L, S/M, S/H, B/L, B/M, B/H (i.e S/L is portfolio consist of those stocks

with small capitalization and low book-to-market ratio). The returns of those six portfolios

are then being used as dependent variables.

They use the excess market return (E(RM) – Rf), which is the difference between the

return on market portfolio, with risk free rate, as proxy for the market factor in stock return.

To capture the size effect, they use the return of portfolio named under SMB (Small

Minus Big). SMB meant to mimic risk factor in returns related to size. It is the difference

(each month) between the simple averages of the return of the three small-stock portfolios

(S/L, S/M, and S/H) and the simple average returns of three big-stock portfolios (B/L, B/M,

B/H). Thus, SMB is the difference between the returns on small and big stock portfolios with

about the same weighted average book-to-market equity.

To mimic capture the risk factor in returns related to book-to-market ratio, they use

the return of portfolio named under HML (High Minus Low). It is the difference, each month,

between the simple average of the returns on the two high book-to-market portfolios (S/H and

B/H) with the simple average returns on the two low book-to-market portfolios (S/L and
B/L). The two components are return on high and low book to market portfolio with about

the same weighted average size.

The same with the case of CAPM, the equation above was meant to predict the expected

return, by which will be unable to be tested statistically, because the expected return is

unobservable. Thus, to be able to be statistically tested, the equation above will be change

into:

Ri - Rf =c + βi (RM – Rf)t + si E(SMBt) + hi E(HML)t +e

Equation 2.4

However, their findings in their earlier research still could not explain the economic

fundamentals’ explanation of size and book-to-market ratio in relation to stock return. Thus,

Fama and French (1995), conducted a study, to find out whether the behavior of stock prices,

in relation to size and book-to-market ratio is consistent with the behavior of earnings. They

confirmed that Book-to-market ratio is related to persistent properties of earnings. High

book-to-market ratio (a low stock price relative to book value) signals sustained low earnings

on book equity. In brief, firms with high book-to-market ratio is firms that are relatively

distress, while those firms with low book-to-market ratio (a high stock price relative to book

value) is typical of firms with high average return on capital (growth stocks). They also

confirmed that size is also related with profitability. Controlling for Book-to-market ratio,

small stocks tend to have lower earnings on book equity than do big stocks. The results

further shows that the common factors in returns mirror the common factors in earnings, and

it suggest that the market, size and book-to-market factors in earnings are the source of the

corresponding factors in returns. The tracks of the market and size factors in earnings are

clear in returns.
2.5 Previous studies

Fama and French (1992) conducted a research using stocks that are listed in New York

Stock Exchange (NYSE), American Stock Exchange (AMEX), and NASDAQ stock market.

They found that there is no cross-sectional relationship between beta and return when other

variables being considered, which are, size and book-to-market ratio. Fama and French

concluded that book-to-market ratio have a positive relationship with return, which means,

the higher the book-to-market ratio, the higher the return of a firm’s stock.

In the continuance of their research, Fama and French (1996), conducted a research

using stocks listed in NYSE for the period 1928-1993. In the research, they stated that their

three factor model, gives a better description compare to single-factor CAPM, and

accommodate most of average return anomalies that are abandoned by CAPM. In this three

factor model, it is stated that the expected return of a portfolio, can be explained using three

factors. The first factor, is the excess return of market portfolio, the second factor is the

difference between the return of portfolio consist of stocks with small capitalization with

those consist of big capitalization (SMB), and the third factor is the difference between the

return of portfolio consist of stocks with low book-to-market ratio with those consist of high

book-to-market ratio.

In the case of emerging market, Nophbannun et al (2009) conducted a study to compare

Fama and French three factor model with CAPM. Their samples are stocks that are listed in

Thailand ctock exchange during 2002-2007. Their study found that Fama and French three

factors model can describe the expected stock return in Thailand Stock market better than the

CAPM does.
2.6 Hypotheses development

Both Fama and French Three factors model and CAPM use the excess return on market

portfolio as explanatory variable to explain expected return of stocks. Both theories proved

that there is a positive relationship between the excess return on market portfolio, with the

average return of portfolio they have constructed.

Bodie et al (2003) explained the logic behind the positive relationship between the

excess return of market portfolio (the equilibrium risk premium of the market portfolio),

with average return on stocks (stocks portfolio). They explained that when investors

purchase stocks, their demand drives up prices, thereby lowering expected rates of return and

risk premium. But if risk premium (excess return of market portfolio) fall, then relatively

more risk-averse investors will pull their funds out of the risky market portfolio, placing

them instead in risk-free assets. In equilibrium, the risk premium on the market portfolio

must be just high enough to induce investors to hold the available supply of stocks. If the

risk premium is too high compared to the degree of risk aversion, there will be excess

demand for securities and price will rise; if it is too low, investors will not hold enough stock

to absorb the supply and price will fall.

Concisely, Brigham and Houston (2007) stated that, considering risk premium is the

premium demanded by investors for investing in the market portfolio, which includes all

risky assets in the market, instead of investing in risk-free assets, then the positive

relationship between risk premium and expected return that the investors willing to get is

positive.

Thus, based on the logic described previously, then the first hypothesis to be developed

is:
Ha1: There is a positive relationship between market risk premium and average return on

portfolio

Fama and French (1992, 1993, 1995,1996) use the return of SMB (Small Minus Big)

portfolio to mimics the risk factors in returns related to size. SMB is the difference between

the average return of portfolio consist of stocks with small capitalization, and portfolio

consist of stocks with big capitalization. Their results show that the slope of SMB is positive

for those portfolios consist of small capitalization.

In their research, Fama and French (1993), shows that SMB as a factor used to mimic

risk related to size, had significant effect on stocks grouped on smaller size portfolio. Their

findings show that SMB, the mimicking return for the size factor, clearly captures shared-

variation in stocks return that is missed by market and by HML. . For every book-to-market

quintiles, the slopes of SMB decrease substantially from smaller size quintile to bigger size

quintiles (1.46 to –0.17 for the lowest book-to-market ratio quintile). The empirical evidence

provided, shows that SMB only had positive effect toward firms with small size. However,

they admitted that the return test still could not tell the full economic story.

To explain the economic fundamentals of the relationship between size and stock return,

Fama and French (1995), study the behavior of stock price, in relation to size and book to

market equity to find out whether it consistent with the behavior of earnings. Using the

percentage change in, EI/BE (Equity income over Book value of equity), EBI (Earning

Before interest) and S (Sales) as dependent variables, they found that the common factors in

fundamentals (earning and sales), drive the risk factor in returns, in this case, size.

. As mentioned previously, in relation with the discussion of size effect, Banz (1981)

refers to Klaim and Bawa (1977) as one of the most possible explanation that can justify the

relationship between size and stock return. They find that if insufficient information is
available for a subset of securities, investors will not hold these securities because of

estimation risk, i.e because of the uncertainty about the true parameters that justifies return

distribution. If investors differ in the amount of information available, they will limit their

diversification to different subsets of all securities in the market. It is likely the amount of

information generated, is related to the size of the firm. Therefore many investors would not

desire to hold the common stock of very small firms. Thus, lack information about small

firms leads to limited diversification and therefore for higher returns for “undesirable” stocks

of small firms. Since this informal logic resulted in the same logic as with the empirical test,

he argued that it was just a coincidences or conjecture.

Dhamodaran (2001), also described about small firm effect. He stated that there are at

least two explanations regarding size effect, in this case, small firm effect, which are: First,

the transaction cost of investing in small stocks are significantly higher than the transaction

cost for investing in larger stocks, and the premiums are estimated prior to these cost. Second,

the capital asset pricing model may not be the right model for risk, and betas underestimate

the true risk of small stocks. Thus, the small firm premium is really a measure of the failure

of beta to capture risk. Moreover, he also mentioned that the additional risk associated with

small stocks may come from several sources, which are: First, the estimation risk associated

with estimates of beta for small firms is much greater than the estimation risk associated with

beta estimates for larger firms. The small firm premium may be a reward for this additional

estimation risk. Second, in line with Klaim and Bawa (1977), he argued that there may be

additional risk in investing in small stocks because far less information is available on these

stocks.

Thus, based on the empirical evidence mentioned above, the smaller the market

capitalization of the stock, the higher the risk related with size (SMB), thus investors will

require higher return to compensate the risk. Then the hypothesis to be proved is:
Ha2: SMB has a positive effect toward return on portfolio consist of small stocks

Fama and French (1992, 1993, 1995, 1996) also used HML (High Minus Low) to

mimic the risks factor in returns related to book market ratio. They found that the slope of

HML increased in every classification of book-to-market ratio. The logic behind the positive

relationship between HML and stock return was explained by Fama and French (1993,

1994,1995). They stated that low book-to-market ratio is typical of firms that persistently

have strong earnings, while high book-to-market ratio is typical of firms that persistently

have low earnings.

In Fama and French (1993), they showed that the slopes of HML increase

substantially for the lowest book-to-market equity quintiles to the highest (-0.29 to 0.62 for

the smallest size quintile). The empirical evidence shows that there is a positive relationship

between portfolio return formed on size and book-to-market ratio, with HML as a factor used

to mimic the risk associated with book-to-market ratio.

Auret and Sinclair (2006), tried to explain the logic behind the recognition of book-

to-market ratio as risk factor. The book value of the firm is the difference between total assets

(resources expected to results in inflows economic benefits) and liabilities (obligation

expected to result in outflows of economic benefit), or a measure of net expected inflows of

economic benefits, or earnings. However, there is an inherent uncertainty surroundings those

earnings. Investment in two firms, each with similar book value to the other, are likely to be

valued differently, if there is more uncertainty surrounding the return of one versus another.

The investment with lesser uncertainty (less risk) is likely to be preferred, to the investment

with grater uncertainty (higher risk), since the marginal utility of risk is assumed to be always

negative, as mentioned by Markowitz (1956). As a result, the market value of the less risky
investment is likely to be higher than the market value of the more risky investment. Since

book-to-market ratio is the ratio of the book value and the market value of the firm, the less

risky investment is therefore likely to have lower book-to-market ratio than a more risky

investment. Given that higher returns are necessary to induce investors to purchase a riskier

investment, a positive relationship between book-to-market ratio and returns emerged.

Moreover, Fama and French (1992) noted that it is possible that the risk captured by

book-to-market ratio is the relative distress factor of Chen and Chan (1991). They stated that

the earnings prospects of firms are associated with a risk factor in return. Firms that the

market judges to have poor prospects, signaled by low stock price and high book-to-market

ratio, have higher expected return (they are penalized with higher cost of capital) than firms

with strong prospects.

Thus, by the expected relationship is that, the higher the book-to-market ratio, the higher

the risk associated with book-to-market ratio (HML), and the higher the return on portfolio

expected from investors. Then, the hypothesis to be proved is:

Ha3 : HML has a positive relationship with average return on portfolio

Many researches compare the effectiveness and the robustness of Fama and French three

factor model and CAPM. Nophbannun et al (2009) conducted a study to compare Fama and

French three factor model with CAPM. Their samples are stocks that are listed in Thailand

stock exchange during 2002-2007. By taking into account the adjusted R 2 obtained by

conducting time series regression on portfolio return from 2002-2007, their study found that

Fama and French three factors model can describe the expected stock return in Thailand

Stock market better than the CAPM does, by generating higher adjusted R2. The average

adjusted R2 of six portfolios obtain from Fama and French three factors model is 62.42%
equally higher than the average adjusted R2 of six portfolios obtained from CAPM which is

29.47%.

Ajili (2001) also compare the use of Fama and French three factor models and Capital

asset pricing model, in the case of France stock market. On the basis of R2 criterion, they

affirm that the three factor model, compared with CAPM, captures better common variation

in stock return. They constructed 6 portfolios same with Fama and French (1992,1993 ,

1994,1996), and added two more portfolios based on only book to market ratio. For the eight

portfolios, they obtained a higher average adjusted R2 with Fama and French three factor

models (90.05%) compare to the average adjusted R2 obtained by CAPM (71.4%).

Thus, by considering the finding of those researches, then the last hypothesis can be

developed as:

Ha4 : Fama and French three factors model, can explain portfolio return better than CAPM

in Indonesian Stock Market.


CHAPTER III

RESEARCH METHODOLOGY

3.1 Data and Sample

This research will take the samples consist of companies that are listed in Indonesian

Stock Market from period 2007-2010. Companies that are being taken into consideration are

all non-financial companies. This research will not use financial companies because their

leverage characteristics are different. Financial companies tend to have high leverage, where

for financial firms, it will implies that the companies is in distress, or having a high risk;

thus if financial companies are included in the research, it will be resulted to bias.

Sampling method that will be used is purposive sampling in which samples that are

being taken into the analysis already have a certain specification so that it can give the

required information needed for the research. . Type of purposive sampling that are being

used is judgment sampling where the choice of subjects which are being taken into the

research are those subjects that will most advantageously placed or in the best position to

provide the information required (Sekaran, 2003)

Thus, under judgment sampling, this research will use the monthly closing price of all

stocks in Indonesian stock exchange which are to be constructed as portfolios and being

used as dependent variable, with the same requirement as Fama and French (1993) used in

their research:

• There is no missing observation of the stock being observed during the period of

research (2007-2010)
• The stock does not have the track record of negative book-to-market ratio during the

period of the research (2007-2010)

• Stocks being used in the research are common stock, so this research will not use

prefer stocks

• Non-financial firms

After sorting all stocks available in Indonesian stock exchange, the data that are being

used in this research consists of 227 stocks (can be seen in appendix 1).

3.2 Data and source of the data

The type of the data that are being used is secondary data that refers to Indonesian Stock

Market Monthly statistics, Indonesian Composite index (IHSG), and risk-free rate (1-month

SBI).

3.3 Identification and variables measurement

a. Return of common stock

Returns of common stocks are calculated by the percentage change in stock’s price from

July (t), to June year (t+1). The formula to calculate the percentage change is as follow:

Rt = CP(t) – CP(t-1)

CP(t-1)

Where Rt is the return of the individual stock in period t, CP(t) is the closing price of the

individual for period t, and CP(t-1) is the closing price of the individual stock for period t-1.

The monthly closing price is being taken from Indonesian stock exchange monthly statistics,

that can be seen in www.idx.co.id . Returns are calculated from July (t) to June (t+1) for

each stock.

b. Risk free rate


Risk free-rate is the rate that an investor can earn by leaving their money in risk-free

assets such as T-bills, money market funds or the bank (Bodie et al, 2008). Thus, the risk

free rate that is being used in this research is 1 month-SBI rate (the rate of Indonesian central

bank’s certificate). The data of 1-month SBI is being taken from the website of Indonesian

central bank, www.bi.go.id

c. Market return

Market return is calculated using monthly closing price of Indonesian Composite Index

(IHSG) taken from www.idx.co.id . The return will be calculated as monthly percentage

change of Indonesian composite index, calculated as:

IHSG(t) – IHSG(t-1)
RM =
IHSG(t-1)

Where RM is market return, IHSG(t) is Indonesian composite index for period t, and

IHSG(t-1) is Indonesian composite index for period t-1.

d. Book to Market ratio

To calculate book-to-market ratio, book value per share and market value per share have

to be calculated first. Book value per share is calculated as assets minus liabilities of the

company, divided by number of shares outstanding, while market value per share is

calculated as the market capitalization of the stocks, divided by numbers of share

outstanding. (Dhamodaran,2001).

Then after finding the book value per share and market value per share, book-to-market

ratio can be calculated as:

Book value/share
Market value per share
As being conducted by Fama and French (1993), this research also use the accounting

data of December (t-1) each year, gained from Indonesian stock exchange monthly statistics.

(www.idx.co.id ). Book to market ratio is being used to group portfolio based on three

groups, which are, those with low book to market ratio, those with medium book-to-market

ratio, and those with high book-to-market ratio.

e. Portfolio return

This research will use six portfolios grouped based on its size and book-to-market ratio,

by which the formation will be explained in the next session. The returns of the six

portfolios as stated by Ajili, (2001) are calculated as follow:

Where:

Rp,t = is the value-weight monthly return of portfolio p in month t

Ri,t = is the monthly return of stock I of portfolio p in month t

Wi,t = is the ratio of market value of stock i on total market value of portfolio p in month t

N = is the number of stocks in portfolio p

f. size

Size of firms, can be judge by its market capitalization. Dhamodaran (2001),

suggested the calculation of market capitalization of a stock as follow:

The numbers of company’s shares outstanding X Market value of the company’s stock
Following the research conducted by Fama and French (1993) and the other research

refer to them; the market capitalizations that are being used in this research is the market

capitalization of each stock\ in every June (t) for 3 years. Market capitalization is being used

as the basis to group stocks into two portfolio categories, one consist of those stocks with big

capitalization, and another one consist of stock with small capitalzion (Fama and French,

1993).

g. Market Factor

Mkt is the excess return between market return and risk free rate. Mkt is being used to

prove that under time series, whether the excess return on portfolio was caused by the

difference in size and book-to-market ratio, or merely because the change in risk free rate

that happen in the market (Fama and French; 1995,1996). Mkt is being used to test the

sensitivity of portfolio return toward Market return. Mkt is calculated as follow:

Mktt = RMt - Rft

Where:

Mktt = excess return of market portfolio for period t

RMt = Market return for period t

Rft = Risk free rate proxied by 1-month SBI rate for period t
h. SMB (Small Minus Big)

Fama and French (1992,1993,1996) used variable SMB (Small Minus Big) to mimic the

risk factor in returns related to size. It is the difference, each month between the simple

average of the returns on three small-stock portfolios, and the simple-average of three big-

stock portfolios. Fama and French (1993) showed the calculation of SMB as follows:

[(S/H + S/M + S/L)] – [(B/H + B/M + B/L)]

Where:

S/H, S/M, S/L = portfolio of stocks with small capitalization, with low, medium and high

book to market ratio.

B/H, B/M, B/L = portfolio of stock with big capitalization, with low, medium, and high

book-to-market ratio.

i. HML (High minus Low)

HML is the variable used by Fama and French (1992,1993,1996), to mimic the risk

factor in returns related to book-to-market ratio. HML is the difference, each month, between

the simple average of the returns on the two-high book-to-market ratio-stocks portfolio, with

the two low-book-to-market-ratio- stock portfolio. Fama and French (1993) showed the

calculation of HML as follows:

[(S/H + B/H)] – [(S/L + B/L)]

2
Where:

S/H, B/H = the portfolio of stocks with high book-to-market ratio, with small and big

capitalizations.

S/L, B/L = the portfolio of stocks with low book-to-market ratio, with small and big

capitalizations.

3.4 Methodology and hypothesis testing

a. First Step

This research is started by forming six portfolios that are formed based on size and

book-to-market ratio, that later on will be used in the identification of SMB variable and

HML. Then the stocks are grouped based on size, into two groups, those stocks with small

capitalization, and those stocks with big capitalization. Individually, stocks are also being

grouped based on their book-to-market ratio and based on the breakpoints, into three groups,

those with low book-to-market ratio (30% of stocks), those with medium book-to-market

ratio (40%), and those with high book-to-market ratio (30%). The decision to group stocks

into three groups on book-to-market ratio and only two groups on book-to-market ratio, is

based on their previous findings in Fama and French (1992), revealed that book-to-market

equity has stronger role in average stock returns than size.

Then six portfolios are formed based on the interception of the two size groups and

the three book-to-market group, they are S/L, S/M, S/H, B/L, B/M, B/H (i.e S/L is portfolio

consist of those stocks with small capitalization and low book-to-market ratio). The returns of

those six portfolios are then being used as dependent variables.


After stocks are being grouped, the next step is applying regression model to the formed

portfolios to see the effect of market factor (as suggested by CAPM), and the effect of the

three factors which are market, SMB and HML as suggested by Fama and French three

factors model.

b. Second step

The regression model that is being used to test Capital Asset Pricing Model, is as

follow:

Rit- Rft = Rft + βi . [RMt – Rft]

The purpose of the empirical model is to test Capital Asset Pricing Model in time

series. Capital Asset Pricing Model stated that the expected return of portfolios is a function

of the two components of which are the risk free rate and market factor (John 2007).

Technical analysis that is being used to estimate the regression in this step is Ordinary Least

Square Method with the use of Eviews 4.0 statistical software. Then hypothesis testing is

being conducted under t-test, to test the significance of independent variable toward

dependent variable. Since in this regression model there is only one variable, then F-test is

not being conducted in this step.

c. Third Step

In the third step, the regression model that is being used is:

Ri - Rf =c + βi (RM – Rf)t + si E(SMBt) + hi E(HML)t +e

The purpose of the regression in this step is to test Fama and French three factor

model in time series manner. Fama and French three factors model suggest that the expected

return on portfolio can be explained by return sensitivity on three factors, which are Mkt

(market factor), SMB, and HML. Technique of analysis that is being used is Ordinary Least
Square using E-views 4.0 statistical software. Hypothesis then will be tested using t-test to

test the significance of independent variable toward the dependent variable (partial test). F-

test is also being used to test whether all independent variables that are being put into the

model, together affecting the dependent variable,

d. Fourth Step

To compare the effectiveness of Capital Asset Pricing model and Fama and French

three factors model, adjusted R2 of both regression in the second and third step are being

compared.

3.5 Classic Assumption test

a. Autocorrelation

Autocorrelation is the existence of relationship between the residual of one

observation, with the residual of other observation. Autocorrelation is easily emerge in the

case of time-series data, because based on the characteristics, current data is affected by the

previous data (Winarno, 2006).

One of the ways to identify autocorrelation that disturbing the regression analysis is

using Durbin Watson (DW test). DW test is only being used for first order autocorrelation,

and required that there is an interception in the regression model and there is no lag variable

in independent variable.

Whether there is autocorrelation problem or not within the model, is based on the

criterion below:

• If the value of DW is higher than upper bound (U), then the coefficient of

autocorrelation is equal to zero, means there is no autocorrelation.


• If the value of DW-statistics is lower than lower bound (L) the coefficient of

autocorrelation is bigger than zero, means there is a positive autocorrelation.

• If the value of DW statistics fall between Upper and Lower bound, then

autocorrelation cannot be conclude.

b. Multicolennierity

Muliticoliniearity is the existence of linear relationship between independent variable

(Gujarati,2003). According to Gujarati (2003), if the correlation between two independent

variable is higher than 0,8 then multicolinierity exist.

c. Heteroskedasticity

Heteroskedasticity is a condition whereby the residual variables have different

variance between one observation to another. It occurs when the residual does not have

constant variance. If heteroscedasticity exist, the estimator of regression will not be efficient,

either in small, or large population.

To identify the existence of heteroscedasticity, scatterplot of the data can be examined

between the predicted value of the dependent variable, and its residual, based on these

assumptions:

• If the scatterplot forms a particular shape, it means that there is heteroscedasticity.

• If the scatterplot does not form any particular shape, or evenly distributed, it means

that there is no heteroscedasticity.


FACTORS AFECTING PORTFOLIO RETURNS IN INDONESIAN STOCK
MARKET:
CAPITAL ASSET PRICING MODEL VS FAMA AND FRENCH THREE FACTORS
MODEL
THESIS PROPOSAL

Submitted by

HARLAN SETIADI

07/257781/EK/16810

INTERNATIONAL UNDERGRADUATE PROGRAM

FACULTY OF ECONOMICS AND BUSINESS

UNIVERSITAS GADJAH MADA


Table of contents:

Chapter 1: Introduction

1.1 Background

1.2 Problem statement

1.3 Limitation of the research

1.4 Purposes of the research

Chapter 2: Theories and Hypothesis development

2.1 The concept of risk and return

2.2 Capital Asset Pricing Model

2.3 The relationship between stock return and firms’ characteristics

2.3.1 The relationship between stock return and firms’ size

2.3.2 The relationship between stock return and firm’s book to market

2.4 Fama and French Three Factor Model

2.5 Previous Research

2.6 Hypothesis development

Chapter 3: Research methodology

3.1 Data and sample

3.2 Data and source of the data

3.3 Identification and variable measurement

3.4 Methodology and Hypothesis testing

3.5 Classic Assumption test

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Fama, Eugene F., and Kenneth R. French, (1995), Size and book-to-market factors in
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Fama, E. and K. French (1996), Multifactor explanations of asset pricing anomalies, Journal
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