CHAPTER # 08

MULTI FACTOR MODELS OF

RISK AND RETURNS

Fama and French Model

CAPM and The Real
World
 A theory or a model is considered good if
it can predict real world better
 CAPM was first introduced in 1964
 Early tests by Black, Jensen and Scholes
(1972) partially supported the CAPM
 They found that average returns were
higher on stocks with higher beta
CAPM and The Real
World (Con’t)
 However, Ross (1977) presented a paper
“A critique of capital asset pricing tests”
in which he heavily criticized CAPM
 Ross argued that since the market
portfolio can never be observed, the
CAPM is unstable.
Arbitrage pricing
theory(APT)
 Ross in the mid-1970s arbitrage pricing
theory (APT).
 The main difference between the CAPM
and the APT is that the latter specifies
several risk factors, thereby allowing for
a more expansive definition of
systematic investment risk than that
implied by the CAPM’s single market
portfolio
Practical problem in APT
implementation
 Despite several appealing features,
one of the practical challenges that
an investor faces when attempting to
implement the APT is that the risk
factors in the model are not defined in
terms of their quantity (i.e., how many
there are) or their identity (i.e., what
they are).
E (R i ) = l0 + b1l1 + b 2 l2 + b k lk
l0 = RFR
l = RISKPREMIUM
b1 = SENSITIVITY
Macro and Micro risk
factors
 Risk factors may be :
 Micro risk factors (Fama and French)
 Macro risk factors ( Inflation, interest
rate, etc)
FAMA and French Model
 FAMA and French presented three factor model
and showed that their model can predict
security returns better than CAPM
 Fama and French (1996) collected data on
those firms that provided above average return
 Then they tried to find out the common
features among these firms
 They observed that historically average returns
are high on:
 Stocks of small firms
 Stocks of firms with high B/M ratio
FAMA and French Model
(Con’t)
 The above two may be proxies for exposure to
systematic risk that is not captured by CAPM i.e.
Small stocks may be more sensitive to changes in
business conditions ( macro-economic factors)
 And firms with high B/M ratio are more likely to be
in financial distress
 These variables capture sensitivity to macro
economic risk factors
 Stocks with the above two features will be more
risky, and the required rate of return should be
higher on them
 (RRR) =Rf+ B1(Rm-Rf) + B2(RSMB) +B3(RHML) +
eFFC
How to make the model
operational
 The following steps are followed:
 Calculate the size premuim over a period of
time
 Calculate the B/M ratio preuim
 Calculate risk premuim on market protfolio
 Calculate returns for a given stock ( e.g FFC
etc) and then put these value in:
 (Rffc –Rf) =Rf+ B1(Rm-Rf) + B2(RSMB) +B3(RHML)
+ eFFC
Size premium
 The size premium is the historical
tendency for the stocks of firms with
smaller market capitalizations to
outperform the stocks of firms with
larger market capitalizations. It is one of
the factors in the Fama–French three-
factor model
Size Premium(SMB)
 1. First sort firms by size
 Size can be measured by the market capitalization,
or assets of the firm
 Calculate the monthly rate of returns on the
largest firms and find the average return
 Calculate the monthly rate of returns on the
smallest firms and find average return
 Calculate the monthly difference between the
average returns of the largest and smallest
firms
Value Premium(HML)
 What Is the Book-to-Market Ratio?
 The book-to-market ratio is used to find
a company's value by comparing its
book value to its market value. 
Value Premium (HML)
 If the market value of a company is
trading higher than its book value per
share, it is considered to be overvalued.
If the book value is higher than the
market value, analysts consider the
company to be undervalued. 
Value Premium (HML)
 Specifically, HML shows whether a
manager is relying on the value premium
by investing in stocks with high book-to-
market ratios to earn an abnormal return.
If the manager is buying only value
stocks, the model regression shows a
positive relation to the HML factor, which
explains that the portfolios returns are
accredited only to the value premium.
Value Premium (HML)
  Obtain the Book for your UNIVERSE companies
for your assigned year
 Calculate the market value
 Calculate B/M ratio = Book value / Market
capitalization
  Place the B/M ratio values in columns next to the
UNIVERSE companies
 Sort the UNIVERSE companies from HIGH to LOW
B/M ratio by using the A   Z function of MS-Excel
on the B/M ratio
      
Value Premium (HML)
 Select the top 5 companies and name this
group of 5 companies as HIGH
  Select the bottom 5 companies and name
this group as LOW companies
  Obtain monthly (end-of-month) closing
share prices for 12 months for the HIGH
companies
  Calculate monthly returns for each
company in the HIGH group
Value Premium (HML)
  Calculate average return for the HIGH in
each month by averaging the returns of
the 5 companies
  Repeat the same process for LOW group
to calculate average monthly return
 Subtract the average returns of LOW from
the average returns of HIGH in each of the
12 months. These monthly differences are
your HML
Calculating return on
large firms
Calculating return on small
firms
Size Premium
Calculating B/M Premium
 Stocks with LOW B/M
High B/M stocks
HML
Final Variables
 Dependent variable = FFC excess return
Results
Interpretation
 1.51(Rm – Rf) = Means if excess return on
market portfolio increases, there will be 1.51
times increase in the excess returns of FFC
stock
 1.35 (SMB) = Means that if the difference in
returns of small and big firms increases, there
will be 1.35 increase in the returns of FFC
 -1.71 (HMB) = measn that if difference in
returns of firms with high and low B/M ratio
increases, there will be 1.71 decrease in the
returns of FFC
 Now the Required Rate of return
 Rf +B(Rm-Rf)+B(SMB)+B(HML)
 Annual Rf = 13%, Annual Rm = 27%
 Annual SMB= 21.%, Annual HML = 29%
 13%+1.51(27-13)+1.35(21.2)-1.71(29)
 13%+ 20.38+ 28.62 - 49.59
 12.41%
 Based on the systematic risk of FFC, investor will
required 12.41% return FCC stock
Multi – Factor Models
 The alternative to the Fama-French approach is to
select macro factor that may be proxies for
systematic risk that affect firms returns
 A research study conducted by Chen, Roll, and
Ross (1986) used extensive list of various
systematic factors affecting returns Like…..
 Change in industrial production
 Change in expected inflation
 Interest rate spread on long term
 Short term bonds
 Unanticipated inflation
 excess return of long term corporate bonds over
long term govt bonds etc.