Fama And French Factor Models For Stock Returns: Implications For Investors

Defining Value and Growth Stocks in "Rethinking Stock Returns"

Questions:

1.How did the Researchers in the Article “Rethinking Stock Returns” define value versus growth stocks? What Relevance did their findings have on Investing?

2.What Factors did Fama and French Examine that may Explain Stock Returns?

3.The CAPM is built on a Single Measure of Risk that Explains Asset Returns. What Measures of Risk did Fama and French Conclude were Necessary to Explain Stock Returns?

4.Describe the CAPM Model and the Fama and French Model and the Implications of these Models for Investors.

The researcher in the article mainly depicted that value stocks provided higher return than growth stocks in major developed countries. In addition, the researcher also pointed out that growth stocks have low book value compared to its market value. However, value stocks have low market value, while its book value is higher. The researcher mainly stated that investors by using value stock are able to attain more return from investment (Fama and French 2016). Moreover, the researcher mainly used 13 different developed countries to understand the impact of value stock on return of investors. In addition, the research findings mainly depicted that value stock are able to provide higher return in comparison to growth stocks. From 1975 to 1995, value stock outperformed in 12 out of 13 developed countries.

Fama and French have mainly identified three factors, which could be used in underrating the return provide by stocks. In addition, Fama and French mainly used the three factors model with the coefficient for identifying the risk and return from investment. Furthermore, Fama and French mainly used price earnings ratio, firm size, book to market equity and leverage to understand the return, which might be provided by companies. However, the researcher mainly identified book to market ratios and size of the firms as most viable factors for identifying stocks with high returns (Fama and French 2016). However, none of the actors used by the Fama and French was highly significant in predicting returns from investment.

Fama and French model mainly used effective risk measures, which could identify the probability of the return provided from investment. In addition, the first risk measure is the market sensitivity, which could be captured by using the CAPM method. The CAPM method mainly helps in identifying the beta of stock in comparison with market return. The second risk measure, which is used by Fama and French, is size of the organisation. Moreover, small companies have higher risk and thus it needs to provide higher return to its investors. The final measure used is the value versus growth from stocks (Fama 2015). The identification of higher value stock could effectively help in generating increased retune from investment.

The first implication of CAPM model is that it is very simplistic, as it ignores the additional risk, which might hinder return from investment. In addition, the second implication is that value stock provides higher returns than growth stocks. Moreover, implications of CAPM model could mainly help the investors in effectively identify the adequate stock with lowest risk and highest return (Cakici 2015). The implication of Fama and French models is that it mainly helps investor in effectively identifying the stock, whose growth could increase in future. The use of market sensitivity, company size and value stocks.

Factors Examined by Fama and French to Explain Stock Returns

Journal used for depicting academic paper Fama- French model:

“Pereira, J., Sorwar, G. and Nurullah, M., 2015. Application of the Fama and French Factor Models to the Credit Default Swaps (CDS) Market.”

Summary of the objective:

The researcher in the above academic paper mainly applied Fama and French, three-factor (3F) and five-factor (5F) models to the CDS market. In addition, the researcher mainly uses daily spreads to perform the tests in the research. Moreover, main aim of the researcher is to test the external validity of Fama and French model. The use of CDS market is mainly appropriate to test the impact of Fama and French model in deriving risk and return. Furthermore, the researcher mainly uses data from previous crisis, crisis, and post crisis for detecting the relevant impact of Fama and French model.  Moreover, the research mainly uses 25 portfolios for analysing the returns that could be provided from Fama and French model. Barbalau et al. (2015) mentioned that investors are not able to rely on theoretical approach during an economic crisis, as risk or return from investment could not be detected in liquidating market.

In addition, the researcher in literature review mainly depicted the formula, which is been used in CAPM model. In addition, the researcher efficiently uses the overall estimation of 3 and 5 factor model to understand its impact on return generation. Furthermore, the Fama and French Model mainly use estimation as if Size based portfolios, Book-to-market portfolios, Investment portfolios, Profitability, and Investment. Moreover, the estimation is mainly useful in depicting 3 and 5 factor model for addressing the overall returns generated from investment. Eraslan (2013) stated that using the Fama French factor model could mainly help investors in identifying stocks, which could contribute the least risk and generate higher return from investment.

Furthermore, the researcher in analysis section mainly used 25 portfolio for identifying the returns, which is been provided by Fama and French model in specific market conditions. In addition, Fama and French model did not provide positive return pre and during the economic crisis, whereas post crisis the portfolio provided adequate return. This only indicates that Fama and French model is an effective tool, which allows the investor to understand the risk and return from investment. Moreover, the researcher mainly used the portfolio to understand the correlation between return and risk. The researcher has also used 3 and 5 factor Fama and French model in the study to detect efficiency of the methods. On the other hand, Barillas and Shanken (2015) argued that Fama and French model does not allow investors to quantify the risk from external factors, which could reduce return and increase risk from investment.

Depicting the main reason behind choosing Fama and French model in the academic research:

The main reason behind choosing Fama and French model in the research is to understand the impact of the model in improving return from investment. In addition, the researcher in empirical results chapter is mainly able to understand the 3F and 5F factor model for deriving the required results for the research. Moreover, the researcher by using the 3F and 5F factor Fama French model could effectively help in identifying the overall significance of its return generation capacity. The researcher also depicted that by using the Fama and French model it could identify the deficiencies of Capital Asset Price Model (CAPM). The Fama and French model is mainly developed for equity market, which could effectively allow investors to identify the return from investment. Buehlmaier and Whited (2016) stated that Fama and French model mainly allows investor to add stocks, which have the least risk and provide the highest return from investment.

Measures of Risk Utilized by Fama and French to Explain Stock Returns

Moreover, the researcher mainly used CDS in deriving efficiency of the Fama and French model. The CDS price changes in the value of the risky and risk free bonds, which could mainly help in depicting the impact of Fama and French model. In addition, the return in CDS mainly reflects the new risk structure, which reduces the impact of CAPM method. In addition, the use of CDS mainly helped the researcher to reduce the impact of CAPM method in analysing the impact of Fama and French factors. The researcher mainly uses CDS returns, as it does not need to identify risk from investment. Thus, the actual impact to Fama and French model factors could be identified. Bharadwaj and Mitra (2016) stated that identification of an effective investment method could help the researcher to pinpoint relative methods, which could increase return from investment.

Moreover, the Fama and French model is mainly used to identify the distress risk and default risk of the overall portfolio, as it might be helpful in making adequate investments. The researcher mainly aims in identifying the impact of risk on portfolio and return generation capacity of the investor. Furthermore, the researcher is mainly able to identify the relevant factors, which affect the overall Fama and French model in generating the required return from investment. in addition, the researcher in this study was mainly intended to understand the impact of each factors on performance of the portfolio, while using combinations and separate factors. This incorporation of different types of factors in portfolio could effectively help in identifying the most useful factors, which could be used by investors to increase their overall profitability. As depicted in the research impact and efficiency of investment models could be reduced during an economic crisis, which hinders ability of the investors to attain more profits (Buehlmaier and Whited 2015). Thus, the researcher in the article mainly aims in identifying the most viable factors in Fama and French model, which could be used in generating high returns for investor in CDS. Lastly, the researcher by using Fama and French model mainly aims in depicting its efficiency in comparison with CAPM model.

References:

Barbalau, A.D.E.L.I.N.A., Robotti, C.E.S.A.R.E. and Shanken, J., 2015. Testing inequality restrictions in multifactor asset-pricing models. Working paper, Imperial College London.

Barillas, F. and Shanken, J., 2015. Comparing asset pricing models (No. w21771). National Bureau of Economic Research.

Bharadwaj, S.G. and Mitra, D., 2016. Satisfaction (Mis) pricing Revisited: Real? Really Big?. Journal of Marketing, 80(5), pp.116-121.

Buehlmaier, M. and Whited, T.M., 2015. Looking for risk in words: A narrative approach to measuring the pricing implications of financial constraints. In Annual Conference of the Western Finance Association (WFA).

Buehlmaier, M.M. and Whited, T.M., 2016. Are Financial Constraints Priced? Evidence from Textual Analysis.

Cakici, N., 2015. The five-factor Fama-French model: International evidence.

Eraslan, V., 2013. Fama and French three-factor model: evidence from Istanbul stock exchange. Business and Economics Research Journal, 4(2), p.11.

Fama, E.F. and French, K.R., 2016. Dissecting anomalies with a five-factor model. Review of Financial Studies, 29(1), pp.69-103.

Fama, E.F. and French, K.R., 2016. International tests of a five-factor asset pricing model. Journal of Financial Economics.

Fama, E.F., 2015. Cross-Section Versus Time-Series Tests of Asset Pricing Models.

Jegadeesh, N., Noh, J., Pukthuanthong, K., Roll, R. and Wang, J.L., 2015. Empirical Tests of Asset Pricing Models with Individual Assets: Resolving the Errors-in-Variables Bias in Risk Premium Estimation.

Pereira, J. and Sorwar, G. (n.d.). Application of the Fama and French Factor Models to the Credit Default Swaps (CDS) Market. SSRN Electronic Journal.