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f# turc
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lChlplcr
o: Hsk. ftetur n. rnd th. Crpitrl Assct Prlcirrll !lo,tcl
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i
and.French digcovered thrt small firms carn con)istcntl)'lri6lrcr irvcrirgc rctrrrns llr,rrt hrgc
firms and, slntllarly, that flrms with high book-to-markc"t r;rtios earn highcr rcturns lhrl
flrmsrvith low'book-to-market ratios. Controlling for lhese trvo cffccts, Farna rnd Frcnth
foupd almost no rclatlonship betwcen bcta and returns. In other words, thc. Sl"ll- rr,as n()t
just'.too flat'; li was completely flat.
t
Wherc does all df this leave'us? Fronr an ocrdemic point of view, ihc arrsrvcr is unccr-
tain. The empirlcal anrt theoretical shortcqrring, ,,f ih.' CAPM lrc by now rvell .lo.u-
mented, and though the literature offers several alternrtivu'a.sset pricing nrocleJs, rtone hits
emerged as the CAPM's clear heir apparent. As a matter o[practice, however, the CAPivt
still reigns supreme in the corporate finance rcalm.
Just
as n)ost U.S. firnrs took to the
CAPM to estimate the required return on their shares, most brokerage and investntent
.advisory
firms still offer estimates of betas as part of their service package. lVhether this
will be the case in another l0 or 20 years is anyonei guess. Tojrepare you for that unccr-
tain future, we now briefly review the leading alternativc to tlic CRPiU: the Farn:r-French
(F-F) three-factor model.
Sl{ARIFrnance
What does it mean to say that early tests of the CAPM indicated that the Slr4L rvas
-too
flat'?
Suppose that, on average, individuals become more risk averse during reces-
sions and less risk averse during economic booms. How might this complicate
tests of the CAPl,4?
6.6 THp Fnua-FRENCH i\,lonrr
\\Ie have alreadv mentioneci the criticisms leveled ai the CAP\{ bf i:i,,rg.-nc lram;r anJ irrt
French in their series o[papers beginning in the early 1990s. It is one thing to criticize,r
theoretical model, but it is another thing entirelY to suggest a n improve rnrnt. Fcrtunr:e,v,
Fama and French did both. Fama and French (i992, 1996, 2A0h) sought to er:lair.i
"ine
cross-section ofexpected returns," or u'hy son:e stocks earn higher ivc'rage reiurns tll;.
oihers. They make two key points in attacking the CAPIl and prrs5g6llng.their alieria'
tive. The first point is that two factors, the size of a firm and the ratio of its equity's book
value to its market value, are systematically related to returns. Looking back through the
'
historical record, Fama and French find that small 6rms earn higher returns than large
'.
firms, even after holding beta ccnstant, and that firms rvith=[igh book-to-market ratios
(value
stocks) outperform firms with low book-to-market rati;(glamour stocks)- The sec:
ond point is that, controlling for firm size and market-to-book ratio, beta has little or no
impact on returns, Why then did early tests of the CAPM indicate that high-beta stoclis
.
earned higher returns than low-beta stocks? Perhaps high-beta stock tend to originate
,' with small firms with high book-to-market ratios. Fama and French argue that.if you'look
at a group of 6rms of similar size (and similar book-to-market ratio), then within that
gouP thehigh&:ta stocks earn about the same returns as low-beta stocks.
The mathematical expression of the Fama-French
(F-D modet is
..
:.
":
. . :
t
'
,,..y,-
Rr= a+ p,r(R^-
R){
fla(R*r-
R*) +
frrt\,nr-
Rr*)
the risk premium on stock i equals a constant term, o, plus a risk premium that depends
cl the stock's sensitivity to each factor and the risk premiurn for each factor. Tlre lerm
P,,
lThctuit
ntltt!tttva/
Jra Cillb\
fi
'i.":iti
14.
15.
i..inr:ic
say ilat
lo caa-
cpcr:ed
,re
OVef i
J;
s fould
':
- , .i.:
lse6 tie ;
,'ll9:;
t
)ngU.5.;i,
9
',.-.:
il CFOs'
.j
: fluctuatd
.., .:. .
itimatest(
'ation-
,:' i
redict rvhni
er, Eugene
of *xplain-.,
ofthe firm
'rti&Fama
(Eq.63!
Xenneti [renc!r. l)artnouth
Coi!ege
'Thc
threc-Jactor nodel is an
oppliiation ol thc arbitragc
pricing thcorl-'
See lhe endre interview at
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