Reinganum (1981) investigates whether, APT predicts the differences in both large firms and

small firms average returns, that is not captured by CAPM. Chen (1983) compares APT and
CAPM and report contrary results with Reinganum (1981) findings. Cho et al. (1986) and
Korajczyk (1988) results support arbitrage pricing theory than that of CAPM by employing
principal component model and factor analysis. Cook and Rozeff (1984) study the negative
impact of size and P/E effect in NYSE stock returns. The undertaken study uses, Basu (1977)
and Banz (1981) methodology for period of 1964-1981. This study suggests that size effect has
an advantage over the P/E effect and these are not consistent with Reinganum (1981) and Bassu
(1981).
French et al. (1987) investigates risk and returns relationship by using GARCH and ARIMA
model for the period of 1928 to 1984 in NYSE. The study reports that volatility and stock returns
have inverse relation. In contrast, market risk is positively related with beta while, preceding
studies reveal that there is no appropriate model for estimating risk effect. Fama and French in
1992 study size and book to market equity jointly to capture the cross section variation in stock
returns associated with market beta, size, leverage, book to market equity and EPS ratio. Fama
and French (1993) introduce three factor models that include market, size and value factors to
explain the variation in average returns.
Fama and French (1992) study the impact of size, book-to-market ratio, market beta, leverage
and P/E ratio on average stock returns in NYSE, NASDAD and AMEX stocks for the period of
1963-1990. Fama and Macbeth (1973) methodology is used to test the process of return
generation. Size, P/E, leverage and book to market equity have significant relationship with
average returns and no explanatory power is observed in case of beta. Meanwhile, size and book-

to-market equity are significant when beta is included in model, size and book-to-market equity
are seem to absorb the effects of leverage and P/E in explaining the average stock returns.
Fama and French (1993) further extends their study to five factors comprising market effect, size
effect; value effect, term effect and default effect by using time series regression approach.
Furthermore, the undertaken study is extended to bonds and stocks of listed companies on
NYSE. Market effect, size effect and the value effect are found significant in case of stocks and
term effect and default effect are found significant in case of bonds. On the basis of results of this
study, Fama and French (1993) proposes a three factor asset pricing model for stocks that consist
of market, size, and the value effect. Three factors model is an extension of the CAPM. The size
effect predicts that firms having low market capitalization earn higher average returns than that
of large size firms. The value effect indicates that firms with higher B/M ratio have higher
returns than that of lower B/M ratio firms.