After the development of the capital asset pricing model (CAMP) in the 1 sass, many empirical tests were developed. The poor performance of the CAMP in explaining realized returns was founded and significant doubts were raised about the beta premium. In Fame and French (1992), various factors were tested (as single explanatory variables and in combinations). The size and book-to-market ratio were found to be the most significant ones for describing returns. These variables were incorporated into the Fame-French three-factor model (FM) which is a modification of the CAMP.

The big difference between the two is that the CAMP was derived from market oratorio theory with a huge list of idealized assumptions, whereas FM is a model developed as a modification of the CAMP to better fit the empirical data. Fame and French (1993) argue that anomalies relating to the CAMP are captured by the FM. The model fits two additional risk factors to the CAMP in order to explain the return variations better and cure the anomalies Of the CAMP.

Hire a custom writer who has experience.
It's time for you to submit amazing papers!

order now

They base their model on the fact that average excess portfolio returns are sensible to three factors namely: (i): excess market portfolio return; (ii): the difference between the excess return on a portfolio of small docks and the excess return on a portfolio of big stocks (SMB, small minus big); and (iii) the difference between the excess return on a portfolio of high- book-to-market stocks and the excess return on a portfolio of low-book-to- market stocks (HIM_, high minus low). They formulate their model as: Where E (Ri): Expected rate of portfolio return.

Ref: Risk-free rate of return. E (ARM-Ref): Expected rate of excess market portfolio return. E (SMB): Expected value of the SMB. E (HEM): Expected value of the HEM. These significant conclusions were found: Small-caps outperformed large- APS and high-B/M stocks outperformed low-B/M stocks. The explanatory variables in the time-series regressions include the returns on a market portfolio of stocks and mimicking portfolios for the size, book-to-market, and term-structure factors in returns.

The returns to be explained are for government bond portfolios in two maturity ranges, corporate bond portfolios in five rating groups, and 25 stock portfolios formed on the basis of size and book-to-market equity. The study uses the same data as Fame and French (1992). Six portfolios are formed from the combinations of these roofs (small/high, small/medium, small/low, big/high, big/medium, big/low). Different time-series regressions were done on each of the 25 size-B/ Importations to compare the explanatory power of the regression of the CAMP against the FM.

The result of empirical test is marginal rejection of the FM by the GRASS tests because the size effect did not occur for the low-book/ market portfolios. Fame and French (1996) point out that the model captures many of the variations in the cross-section of average stock returns, and it absorbs most of the anomalies that have plagued the CAMP. In the same study they argue that the empirical success of their model suggests that it is an equilibrium pricing model.

However, a number of studies have reported that when the Fame-French model is applied to emerging markets the book- to-market factor retains its explanatory ability but the market value of equity factor performs poorly. This FM still needs to be adjusted to better capture the reality, for example, an alternative three factor model that replaces the market value of equity component with a term that acts as a proxy for accounting manipulation.