Intermediate Finance Project (Slot 4) Usama Humayoon 2013-02-0457 1.

The Fama and French (1993) three factor model was developed as a result of increasing empirical evidence that the Capital Asset Pricing Model (CAPM) performed poorly in explaining realized returns. In fact, Fama and French 1992 paper The Cross Section of Expected Stock Returns studied the joint roles of market beta, size, Earnings/Price ratio, leverage and book-tomarket equity ratio in the cross-section of average stock returns for NYSE, Amex and NASDAQ stocks over the period 1963-1990. In that study, the authors find that beta has almost no explanatory power. Fama French therefore argued that if stocks are priced rationally, risks must be multidimensional. As a result, Fama and French in 1993 paper entitled Common Factors in the Expected Returns on Stocks and Bonds constructed a three-factor asset pricing model for stocks that includes the conventional market (beta) factor and two additional risk factors related to size and book to market equity. The model says that the expected return on a portfolio in excess of the risk free rate is explained by the sensitivity of its return to three factors: (i) the excess return on a broad market portfolio, (ii) the difference between the return on a portfolio of small stocks and the return on a portfolio of large stocks (SMB) and (iii) the difference between the return on a portfolio of high-book-to-market stocks and the return on a portfolio of low-bookto- market stocks (HML). The model is as follows: R = Rf + beta3 x (Km - Rf) + bs x (SMB) + bv x (HML) + alpha

Where: R is the portfolio's rate of return, Rf is the risk-free return rate, Km is the return of the whole stock market. The "three factor" is analogous to the classical but not equal to it, since there are now two additional factors to do some of the work. SMB (small minus big): difference between returns on diversified portfolios of small and large capitalization stocks. HML (high minus low): difference between returns on diversified portfolios of high (distressed firms) and low B/M (not distressed firms) stocks Moreover, once SMB and HML are defined, the corresponding coefficients bs and bv are determined by linear regressions and can take negative values as well as positive values. It can be seen that the Fama and French three-factor model is more like an extension of the CAPM. The Fama-French Three Factor model explains over 90% of the diversified portfolios returns, compared with the average 70% given by the CAPM. In fact, the model augments the CAPM model by the size effect and the book-to- market equity effect. The size effect is the empirical regularity that firms with small market capitalization exhibit returns that on average significantly exceed those of large firms. The book to-market equity effect shows that average returns are greater the higher the book value to market-value ratio (BE/ME) and vice versa. It is also referred to as the value premium. The high book value firms are under-priced by the market and are therefore good buy and hold targets, as their price will rise later. Fama and French analyzed the characteristics of firms with high book-to-market and those with low book-tomarket equity. They find that firms with high BE/ME tend to be persistently distressed and those with low BE/ME are associated with sustained profitability. They conclude that the returns to

holders of high BE/ME stocks are therefore a compensation for holding less profitable and riskier stocks. The high book-to-market stocks favored by the strategy became known in the academic literature as value stocks while the low BE/ME stocks DFA eschewed became known as growth stocks, or sometimes as glamour stocks. It argued that value stocks outperformed growth stocks for the only reason any asset consistently outperforms in a rational, efficient market.

2. Dimensional Fund Advisors (DFA) have been growing steadily and profits have been strong. As of 2010, DFA was ranked as the overall best performing fund family based on Barrons/Lipper ranking. The strategies used by DFA are largely based upon research that has been conducted by Eugene Fama and Kenneth French. Fama is regarded as the father of the Efficient Market Hypothesis; describing the market as having three forms of efficiency: strong form, semi strong form and weak form. DFA bases their approach on the efficient market principle and number of others which are: A) One-Year Fixed Income Strategy: With no prediction of interest rates, Eugene Fama develops a method of shifting maturities that identifies optimal positions on the fixed income yield curve. Relative performance in fixed income is largely driven by two dimensions: bond maturity and credit quality. Bonds that mature farther in the future are subject to the risk of unexpected changes in interest rates. Bonds with lower credit quality are subject to the risk of default. Extending bond maturities and reducing credit quality increases potential returns. Since it is impossible to predict what will happen with interest rates in the future, DFA diversify broadly and use a "variable maturity" approach in most of our portfolios. This approach, which was developed by Professor Eugene Fama, uses the current yield curve to determine optimal maturities and holding periods. To maximize expected returns, DFA strategy is to choose shorter maturities in flat or inverted yield curve environments and longer maturities in upwardly sloped curves. Maturities are shifted in response to changes in the current yield curve. B) Tax Management: Dimensional tax-managed strategies implemented to maximize after-tax returns by offsetting gains and minimizing dividends. Based on Fama/French research, DFA opened new opportunities for taxable investors. Asset classes that were previously suited to non-taxable investors now make sense for everyone. The Fama/French research found a way to offset gains and minimize dividends without sacrificing strong diversified exposure to specific asset classes or across asset classes. C) U.S. Small Value investment: Dimensional Fund Advisor value strategies are based on the Fama/French research paper entitled, The Cross-section of Expected Stock Returns in which he showed that stocks with a high ratio of book value of equity to market value of equity (BE/ME) known as value stock exhibited consistently higher returns than stocks with low BE/ME known as growth stock and

are designed to capture the return premiums associated with high book-to-market (BtM) ratios. DFAs U.S. Small Value investment fund is based around this new strategy. D) International value funds: Fama and French again performed a test to show the effect of book to market effect but this time with international data. Morgan Stanley Capital International had carefully collected data on thousands of firms in dozens of countries. These data included book value, dividends, and earnings, as well as stock price and stock return information. Fama and French analyzed these data and found once more that the book-to-market effect was robust. High book-to-market stocks outperformed low in virtually every country studied. Based on these findings, DFA expanded its product offerings by introducing international value funds, much as it had introduced international small-stock funds in years past.

3. As stated there are many papers written improving or adding upon Fama French model. I have chosen the most significant papers and they are: A) Carhart, M. M. (1997). On Persistence in Mutual Fund Performance: In this paper Carhart introduces The four-factor model used in evaluating fund performance is motivated by Carhart (1997), who finds that the one year momentum anomaly documented by Jegadeesh and Titman (1993) explains the persistence in mutual fund performance documented in prior literature. The model used is similar to the Fama-French three-factor model, with additional factor MOM to capture momentum. According to Carhart (1997), the model can be thought of as a performance attribution model, where the coefficients on the factor-mimicking portfolios indicate the proportion of mean return explained by the four factors. The Carhart (1997) four-factor models specified as follows; R = Rf + beta3 x (Km - Rf) + bs x (SMB) + bv x (HML) + bm x (MOM) + alpha SMB and HML factors are calculated as per the Fama-French (1992) three-factor model. MOM is a momentum factor which represents the difference in returns between the top and bottom third of All Ordinaries stocks, ranked on the basis of their prior six-month returns, lagged by two months. B) An Augmented Fama and French Three-Factor Model: New Evidence From An Emerging Stock Market by Sunil K Bundoo In this paper it is showed that there is a lack of empirical evidence of whether the size and value premium are present in emerging equity markets generally, and particularly in the emerging African stock markets. This study provides some empirical evidence in an emerging market, the Stock Exchange of Mauritius, and offers additional out of sample evidence that the size and the book-to-equity effects are international in character. It also innovates by augmenting the Fama and French three-factor model. One may expect that a Fama and French three-factor that takes into account the time-variation in risk, the significance of the size and book-to-market equity effects may be reduced or even disappear. The empirical results confirm that the Fama and French (1993) three factor model holds for the Stock Exchange of Mauritius. Moreover, the

empirical results for the augmented model show that the Fama and French three factor model is robust after taking into account time-varying betas. C) The Cross-Section of Volatility and Expected Returns by Andrew Ang, Robert J. Hodrick, Yuhang Xing, and Xiaoyan Zhang In this paper they examined the returns of a set of test assets that were sorted by idiosyncratic volatility relative to the Fama-French (1993) model. They uncover a very robust result. Stocks with high idiosyncratic volatility have abysmally low average returns. In particular, the quintile portfolio of stocks with the highest idiosyncratic volatility earns total returns of just -0.02% per month in their sample. However, their estimate of a negative price of risk of aggregate volatility is consistent with a multifactor model. D) Asset Pricing, the Fama-French Factor Model and the Implications of Quantile Regression Analysis by David E. Allen, Abhay Kumar Singh and Robert Powell In traditional tests of asset pricing theory Ordinary Least Squares (OLS) regression methods are used in empirical tests of factor models, which implies a focus on the means of the distributions of covariates. The work of Koenker and Basset (1982) and Koenker (2005) provides an alternative via Quantile regression featuring inference about conditional quantile functions. This study empirically examines the behaviour of the three risk factors from Fama-French Three Factor model of stock returns, beyond the mean of the distribution, by using quantile regressions and a US data set. The study not only shows that the factor models does not necessarily follow a linear relationship but also shows that the traditional method of OLS becomes less effective when it comes to analyzing the extremes within a distribution, which is often of key interest to investors and risk managers. E) Further Evidence on the Risk-Return Relationship by Yakov Amihud, Bent Jesper Christensen and Hairn Mendelson In this paper they presented two econometric techniques to test the capital asset pricing model (CAPM) : (1) a joint pooled cross-section and time-series estimation procedure, and (2) the use of generalized least squares estimation This method of estimation produces more efficient estimates and more powerful tests than those obtained by the FM methodology A recent study by Fama and French (1992) which applied, in the main, the FM method found an insignificant return Beta relationship. This implies that there is no support for the major dictum of the CAPM However, using our methodology we reach different conclusions. Replicating the FM methodology, we found that the return Beta relationship is insignificant, consistent with FF. However, using the same data and employing the joint pooled time-series and cross-section estimation, we obtained a significantly positive coefficient of average return on Beta.

4. Microsoft Stock CAPM calculation Regression Statistics Multiple R 0.517847201

R Square Adjusted R Square Standard Error Observations

0.268165723 0.263083541 9.914397565 146 Standard Error t Stat P-value 0.821497295 -0.97785 0.329787 0.16703359 7.264011 2.18E-11

Intercept Mkt-RF

Coefficients -0.80330372 1.21333387

Expected Return = Rf + beta*(Mkt-Rf) Expected Retun = 2.654 + 1.21 * 2.876 Expected Return = 6.134% Fama French three factor model calculation Regression Statistics Multiple R 0.576127 R Square 0.331922 Adjusted R Square 0.317808 Standard Error 9.539168 Observations 146 Standard Error t Stat P-value 0.803461 -0.59402 0.553441 0.165599 6.605538 7.38E-10 0.218663 0.94002 0.348804 0.223254 -3.01116 0.003081

Intercept Mkt-RF SMB HML

Coefficients -0.47727 1.09387 0.205547 -0.67225

Expected Return = Rf + beta1*(Mkt-Rf) + beta2*(SMB) + beta3*(HML) Expected Return = 2.64 + 1.09*2.876 + 0.21*2.998 + -0.67*6.23 Expected Return = 2.23%

Company X Stock

CAPM calculations Regression Statistics Multiple R 0.018844 R Square 0.000355 Adjusted R Square -0.00654 Standard Error 4.554249 Observations 147 Standard Error t Stat P-value 0.376228294 2.860743 0.004852 0.076385091 -0.22695 0.820781

Intercept Mkt-RF

Coefficients 1.076292461 -0.0173356

Expected Return = Rf + beta*(Mkt-Rf) Expected Return = 2.66 + (-0.017)*3.337 Expected Retutn = 2.6% Fama French three factor model calculations Regression Statistics Multiple R 0.231901282 R Square 0.053778204 Adjusted R Square 0.033927398 Standard Error 4.461761527 Observations 147 Standard Error t Stat P-value 0.374319414 2.52573208 0.012635647 0.077166233 -0.68750079 0.492880755 0.102232369 2.819459024 0.005493466 0.104139399 1.307086489 0.193281245

Intercept Mkt-RF SMB HML

Coefficients 0.945430553 - 0.0530518 0.288239975 0.136119202

Expected Return = Rf + beta1*(Mkt-Rf) + beta2*(SMB) + beta3*(HML) Expected Return = 2.66 + -0.53*3.337 + 0.288*3.069 + 0.136*5.914 Expected Return = 4.17%

5. The validity of both CAPM and Fama and French models can be judged from the value of intercept. An asset valuation model is considered valid if: 1. Value of intercept is zero or closer to zero OR 2. The intercept is statistically insignificant. The intercept is considered statistically insignificant when its P-value is above 0.1. The value of intercept in case of Microsoft stock is -.477 which shows that Fama and French model predicts 47.7% risk premium above the actual risk premium. However, this value is insignificant as the P-value is 0.55 which is above 0.1. The value of intercept, being insignificant, suggests that Fama and French model is valid. But the one additional variable of Fama and French is insignificant as well. SMB is insignificant as its P-value is above 0.1. The result shows that SMB have no relationship with the dependent variable (Ri-Rf). This is against the basic foundation of FF model. The intercept has a value of -.80 which suggests that CAPM also gives expected risk premium above the actual risk premium by a value of 80%. But this value is insignificant as the P-value is 0.329 which is above 0.1. The beta is highly significant as the P-value is well below 0.1. In both of the regression outputs of Fama and French and CAPM, the intercept values were insignificant, suggesting that both models correctly predict the risk premium on the given security. However, Fama and French model fails to confirm to its own predictions as both of its main variable showed no relationship with the actual risk premium (Ri-Rf). On the other hand, CAPM seems to be right in its prediction that a security risk premium is dependent upon the risk premium of market portfolio and a securitys beta. This is why CAPM is the preferred model in our case. The value of intercept is in case of Company X stock is -.94 which shows that Fama and French model predicts 94% risk premium below the actual risk premium. Also this value is significant as the P-value is 0.012 which is below 0.1. The value of intercept, being significant, suggests that Fama and French model is invalid. Also one additional variable of Fama and French is insignificant as well. HML is insignificant as its P-value is above 0.1. The result shows that HML have no relationship with the dependent variable (Ri-Rf). This is against the basic foundation of FF model. The intercept has a value of 1.07 which suggests that CAPM gives expected risk premium below the actual risk premium by a value of 107%. And this value is significant as the P-value is 0.0048 which is below 0.1. The beta is also highly insignificant as the P-value is above 0.1. So the both model are not valid in this case and cannot be relied.

One of the major reasons for this is that the R-square of both the stocks is significantly less, hence leading to the conclusion that the stocks according to R-square are not a viable option. We need to consider the fact that in a stock market there are many factors working at hand, and not all of these factors can be incorporated in our statistical analysis. This leads to incomplete data and information to run a regression and make a significant decision on the current stocks. With our experience we have learnt that there is no hard and fast rule in the trading of stocks. Two similar situations of two different stocks dont necessarily have the same end. In most cases one stock can have a very favorable end whereas the other one having a completely opposite effect. One of the basic tests that we could run to determine which stocks should be traded in is, by calculating the price to earnings ratio. This explains us in general the type of company one is and their policies. A company with a high P/E ratio suggests that the earnings per share of that company are less, which can indicate that the company is holding on to profits in hopes of reinvestment. A company such as this has high capital gains and dividends but both of these things are for the long term, neither affecting the P/E ratio. These companies are suggested to be developing companies which may result in handsome capital gains. A company with a low P/E ratio just suggests that it has reached its peak and any chances of earnings with respect to capital gains are meager. Another test that can be very helpful is trying to figure out the intrinsic value of a stock. This can be calculated in many different ways. Although the gist of it is to figure out which stocks are overvalued and which undervalued. This helps us in this way that it points out the stocks true value. An undervalue stock is always expected to have a price rise to meet its true intrinsic value because that is what the market values the stock to be, whereas an overvalued stock is expected to fall. These methods just point out the basic reasons of how and why intrinsic value can be important.