7.2 Fama French tests

Question 1

Result of Fama French:

CAPM predicts that variation in expected returns should only be explained by …

Former studies (e.g., Fama and McBeth (1973) have confirmed that prediction.

However, Banz (1981) and Basu (1977) have asserted that returns seem to be correlated to …

Chan et al. (1991) find that book-to-market, BE/ME, has a strong predictability power on Japanese stocks.

Answer 1

differences in betas

firm size or firm’s earnings-price ratios.

Question 2

Fama/French: The 3-Factor Model

The results.

Answer 2

Book-to-Market ratio has autonomous impact in explaining returns.

Market ß is not significantl.

Size and Book-to-Market ratio are significant in all specifications.

After controlling for size, size and B-M-R lost their significance.

Question 3

Factor construction

• The size factor reflects the … that is … (small minus big). All stocks are divided in two groups; Fama/French are using the median market cap at the NYSE as the critical value.
• The value factor reflects the performance of a portfolio that is … (high minus low). For the long-portfolio only the 30% of the stocks with the highest
  book-to-market values are used, for the short portfolio the 30% of the stocks with
  the lowest book-to-market values

Answer 3

performance of a portfolio
long in small and short in large stocks

long in stocks with high book-to-market values and short in stocks with low book-to-market values

Question 4

For the rest, review the slides. (Slide 30, economicrationale of ff3fm etc…)

Answer 4

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