FAMA-FRENCH THREE-FACTOR MODEL

ANAMIKA & VEDIKA

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 OUTLINE

 Background

 Defining the five risk factors- stock and bond market

 Size and Value-are these risk factors?

 Construction of portfolios

 Sources of Data Collection

 Explanation of the model- Common Variation in returns

 Joint tests on the regression intercepts

 Applications of the paper

 Questions probing further research 2

BACKGROUND

 CAPM Model: describes the relationship between systematic risk and expected return for assets, particularly
stocks.
 Used for pricing risky securities and generating expected returns for assets given the risk of those assets and cost
of capital.
 An extension to asset pricing model CAPM
 Fama and French (1992, 1993, 1995, 1996, 1998, 2006, 2014)

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DEFINING THE FIVE RISK FACTORS: 3 STOCK MARKET FACTORS
(1) Market risk premium (proxy: excess market return Rm-Rf) as in CAPM

(2) "Size“ Captured by SMB = “small [market capitalization] minus big”

 Differential return of small stocks minus big stocks.
 When small stocks do well relative to large stocks this will be positive, and when they do worse than large
stocks, this will be negative.

(3) "Value“ Captured by HML = “high [book/price] minus low”.

 It refers to return differential of high book-to-market stocks minus low book-to-market stocks.
 This is the return of value stocks minus growth stocks, which can likewise be positive or negative.
 The value effect refers to the fact value stocks outperform growth stocks, on average.
2 BOND MARKET FACTORS

(1) Unexpected changes in interest rates: ‘TERM’ serves as a proxy for this :
Difference between Monthly long-term government bond return and the one month
treasury bill rate(measured at the end of previous month)
(2) Default risk: ‘DEF’ proxy for this : Difference between return on a market
portfolio of long-term corporate bonds and long –term government bonds returns.
SIZE AND VALUE: ARE THESE RISK FACTORS?

 Both are related to economic fundamentals

 Reason for B/M : Firms that have high BE/ME tend to have low earnings on assets, and
the low earnings persist for at least five years before and five years after book-to-
market equity is measured. Conversely,low BE/ME is associated with persistently high
earnings.
 Fama and French argue that smaller firms are riskier because they may have greater
difficulty surviving recessionary periods.
 Fama and French also argue that stocks with low market prices relative to their book
values(‘Value stocks’) may be in “financial distress”.
 Not everyone agrees that these are risk factors.
Construction of Portfolios

SMB= 1/3 (Small Value+Small Neutral+Small Growth)- 1/3(Big value+Big Neutral+Big Growth)
HML= ½ (Small Value+Big Value)- ½ (Small Growth+Big Growth)
MODEL/ FORMULA (FAMA-FRENCH, 1992)

Rit – Rft = αit + βiM (RMt - Rft) + βisSMBt + βihHMLt + εit

Rit is the total return of individual stock/portfolio i

Rft is the risk free asset return
RMt is the total market portfolio return
Rit – Rft is expected excess return
RMt - Rft is the excess return on a market portfolio index
SMBt is the size premium
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HMLt is the value premium

 SOURCES OF DATA COLLECTION
• Pricing data includes stocks from:
• NYSE
• AMEX
• NASDAQ

• Date Ranges from 1963 to 1991

• Data collected from CRSP and COMPUSTAT
• Two maturity ranges:1-5 year and 6-10 year government bonds (from CRSP)
• Corporate bond data fetched from Ibbotson Associates (in collaboration with
Dimensional Fund Advisors)
• 5 Rating Groups: Corporate bonds rated Aaa, Aa, A, Baa and below Baa(Low Grade
Bonds) by Moody
EXPLAINING THE RETURNS

 Summary of dependent and explanatory returns.

 Dependent variables (dependent returns): Average excess returns on the
portfolio
 Explanatory variables (explanatory returns): Average premiums per unit
of risk for the candidate common risk factors in returns
DEPENDENT RETURNS

Bonds
 The average excess returns on the government and corporate bond
portfolios in table 2 are small/weak. All the average excess bond returns
are less than 0.15% per month,

Table 2
DEPENDENT RETURNS

Stocks:
 Wide range of average excess returns, from 0.32% to 1.05% per month.
 Confirms the Fama-French (1992a) evidence that there is a negative relation
between size and average return, and there is a stronger positive relation between
average return and book-to-market equity.

Table 2
EXPLANATORY RETURNS
 The average value of RM-RF (the average premium per unit of market Beta) is 0.43% per month. This is large
from an investment perspective (about 5% per year), but it is a marginal 1.76 standard errors from 0.
 The average SMB return (the average premium for the size-related factor in returns) is only 0.27% per month
(t = 1.73).
 The book-to-market factor HML. produces an average premium of 0.40% per month (t = 2.91), that is large in
both practical and statistical terms.

Table 2
CONTD..

 The average risk premiums for the term-structure factors are trivial relative to those of the stock-
market factors. TERM (the term premium) and DEF (the default premium) are on average 0.06% and
0.02% per month; both are within 0.3 standard errors of 0.
 The low means and high volatilities of TERM and DEF will be advantageous for explaining bond
returns. But the task of explaining the strong cross-sectional variation in average stock returns falls on
the stock-market factors. RM-RF, SMB, and HML which produce higher average premiums.
COMMON VARIATION IN RETURNS

 The slopes and R2 values are direct evidence on whether different risk factors
capture common variation in bond and stock returns. .
 The purpose is to test for overlap between the stochastic processes for stock and
bond returns. Do bond-market factors that are important in bond returns capture
common variation in stock returns and vice versa?
 Individually considered bond-market and stock-market factors.
Variation in returns- TERM factor
Variation in returns- DEF Factor
 STOCK MARKET FACTORS

The role of stock-market factors in returns is developed

in three steps.
(a) regressions that use the excess market return,
RM-RF, to explain excess bond and stock
returns,
(b) regressions that use SMB and HML, the mimicking
returns for the size and book-to-market factors, as
explanatory variables and
(c) regressions that use RM-RF, SMB and HML.
(b) regressions that use SMB and
HML, the mimicking returns for
the size and book-to-market
factors, as explanatory variables

• The slopes on SMB for stocks are

related to size. In every book-to-
market quintile, the slopes on SMB
decrease monotonically from
smaller- to bigger-size quintiles.

• In every size quintile of stocks, the

HML slopes increase monotonically
from strong negative values for the
lowest BE/ME quintile to strong
positive values for the highest-
BE/ME quintile.
 (c ) Regressions that use RM-
RF, SMB and HML.

• In general. adding SMB and HML to the

regressions collapses the beta for stocks
toward 1.0: low beta move up toward 1.0
and high beta move down. This behavior
is due of course to correlation between
the market and SMB or
HML(uncorrelated).
STOCK MARKET AND BOND MARKET FACTORS (COMBINED)
ORTHOGONALIZED MARKET FACTOR
 JOINT TESTS ON THE REGRESSION INTERCEPTS

 Use of F-statistic of Gibbons, Ross. and Shanken (1989) to formally test the hypothesis that a set of explanatory variables produces
regression intercepts for the 32 bond and stock portfolios that are all equal to 0.
 Gibbons, Ross & Shanken (1989) test,which tests whether the factors fully explain the expected returns of various portfolios.
 The tests reject the hypothesis that the term-structure returns, TERM and DEF suffice to explain the average returns on bonds and
stocks at the 0.99 level.
 The F-test rejects the hypothesis that RM-RF suffices to explain average returns at the 0.99 level.
 The large positive intercepts for stocks observed when SMB and HML are the only explanatory variables produce an F-statistic that
rejects the zero-intercepts hypothesis at the 0.98 level.
 The joint test that all intercepts for the seven bond and 25 stock portfolios are 0 rejects at about the 0.95 level.
 The three stock-market factors, RM-RF, SMB, and HML, produce the best-behaved intercepts.
 APPLICATIONS OF THE PAPER
 Selecting Portfolios:
- The exposures of a candidate portfolio to the five risk factors can be estimated with a regression of the
portfolio’s past excess returns on the five explanatory returns.
- The regression slopes and the historical average premiums for the factors can then be used to estimate the
expected return on the portfolio.
- Using the results for portfolio formation and performance evaluation is even simpler for portfolios that
hold only stocks.
 Evaluating Portfolio Performance:
- If the results of the paper are taken at face value, evaluating the performance of a managed portfolio is
straightforward.
- The intercept in the time-series regression of the managed portfolio’s excess return on the five
explanatory returns is the average abnormal return needed to judge whether a manager can beat the
market, that is, whether s/he can use special information to generate average returns.
CONTD..

 Measuring abnormal return in event studies:

The residuals from three-factor regressions that also use SMB and HML will do a better
job isolating the firm-specific components of returns- help in analyzing stock price
response to firm-specific information(event).
 Estimating the cost of capital:
Similar to the use of CAPM while calculating cost of equity- cost of capital can be
computed.
QUESTIONS PROBING FURTHER RESEARCH

 How does profitability or any other fundamental, produce common variation in

returns associated with size and BE/ME that is not picked up by the market return?
 Can specific fundamentals be identified as state variables that lead to common
variation in returns that is independent of the market and carries a different premium
than general market risk?
 How the size and book-to-market factors in returns are driven by the stochastic
behavior of earnings?
THANK YOU