The Conditional Relation between Fama-French Betas and Return

Abstract

According to asset pricing theory, in expectation there is a positive reward for taking risks. However, using realized returns, this relation is frequently reversed. In order to take this into account, we apply a conditional approach to the predominant model in asset pricing, the Fama-French three-factor model. We find that all three risk factors cross-sectionally drive asset returns. While other papers stop their analysis at this point, we extend the test developed by Freeman and Guermat (2006) to multifactor models and test if risk premia are priced within the conditional approach. Our test leads to qualitatively identical results as the widely used Fama-MacBeth test and hence confirms its validity.

Keywords: Empirical Asset Pricing, Beta Risk, Fama-French, Asymmetric Risk, Bootstrap

JEL Classification: G12