Fama and French: Corporate Finance

Pages: 5 (1703 words) Published: May 21, 2014
Corporate Finance: Assignment

Fama explains that efficient market hypothesis believes that “security prices fully reflect all available information,” (Fama, 1970, p.1575) and thus only unexpected information should impact a security’s price. Informational efficiency prevents the ability to attain increased average returns utilising technical and fundamental analysis. Security prices follow a “random walk,” this implies that tomorrow’s price is independent from its earlier prices (Brealey et al, 2008). Studying the time lag from when new information is published to the change in the security’s price can suggest efficiency; the market is efficient if the time lag is short, indicating that information is integrated into stock prices very quickly. There are three defined forms of efficient market hypothesis. A market is weak form if all information built into previous prices is also incorporated into the security price (Brealey et al, 2008). The implication of this form is that technical analysis cannot be employed to obtain abnormal returns since all security market data is already built into security prices. A market is semi-strong form if all security market data and all public information (e.g. political) have been built into stock prices (Brealey et al, 2008). The implication of this form is that fundamental analysis cannot be used to generate abnormal returns. A market is strong form if all security market data, public information and also private information are built into security prices. The significance of this form is that nobody including insiders can produce irregular profits.

Malkiel explains market efficiency that “such markets do not allow investors to earn above-average returns without accepting above-average risks” (Malkiel, 2003, p.60). The capital asset pricing model (CAPM) is an equilibrium model of stock pricing. The security market line (SML) displays the relationship between risk and expected return on an investment and is computed by: E(Ri) = Rf + β(Rm – Rf). If all securities are priced correctly, the market is in equilibrium, and all investments are positioned on the SML. Rm – Rf specifies the excess return of the market (market risk premium). Rf is the intercept. It is not possible to obtain excess returns when investing in a portfolio that is made up of only risk free assets. The market beta of a security is “the covariance of its return with the market return divided by the variance of the market return,” (Fama and French, 2004, p.28) and this reveals the magnitude of a security’s systematic risk. The market portfolio has a beta equal to 1. In a competitive market the expected excess return of a security is proportional to the degree of systematic risk (Brealey et al, 2008) In CAPM, the expected excess returns of a security (dependant variable) is explained utilising only one predictor, risk premium of market, but is one explanatory variable enough?

Fama and French show that average stock returns on firms with small market capitalization have been significantly higher than the average returns for “large cap” firms. Explanations for this result will be explored and whether the findings documented by Fama and French refute market efficiency. Market capitalization is equal to the “stock price times shares outstanding” (Fama, 1970, 1578). Evidence suggests returns can be forecasted from historical returns. Lo and MacKinlay (1988) (cited in Fama 1970, p.1578) discover that a positive autocorrelation exists for weekly returns on portfolio of NYSE stocks. Furthermore the autocorrelation from small stocks is found to be larger. When autocorrelation is not equal to zero, then future values of a variable can be explained by current and past values of its own variable. After shrinking the impact of non-synchronous trading Conrad and Kaul (1988) (cited in Fama 1970, p.1579) obtain evidence that also support the findings of Lo and MacKinlay. They determine that the first order autocorrelation of...
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