Common Risk Factors In Stock And Bond Returns Fama French Reading Summary

Topics: Capital asset pricing model, Investment, Modern portfolio theory Pages: 2 (680 words) Published: April 15, 2015
Reading Summary of Common risk factors in stock and bond returns Xin Shi (A13119523) The paper introduces the famous Fama–French three-factor model which is a development of the traditional CAPM model and the findings of the 1992 paper. It believes the theory should be able to explain not only stock but also bond returns. Also this paper uses the method of time-series regression, which is quite different from the previous paper. After the development of the capital asset pricing model (CAPM) in the 1960s, many empirical tests were developed. The poor performance of the CAPM in explaining realized returns was founded and significant doubts were raised about the beta premium. In Fama 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 Fama–French three-factor model (FF3M) which is a modification of the CAPM. The big difference between the two is that the CAPM was derived from market portfolio theory with a huge list of idealized assumptions, whereas FF3M is a model developed as a modification of the CAPM to better fit the empirical data. Fama and French (1993) argue that anomalies relating to the CAPM are captured by the FF3M. The model fits two additional risk factors to the CAPM in order to explain the return variations better and cure the anomalies of the CAPM. 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 stocks 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 (HML, high...
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