The Fama and French Three-Factor Model and Leverage: Compatibility with the Modigliani and Miller Propositions

Abstract

The issue of whether the Fama and French (FF) three-factor model is consistent with the propositions of Modigliani and Miller (MM) (1958, 1963) has received surprisingly little attention. Yet, unless it is so, the model is at variance with the foundations of finance. Fama and French (FF) (1993, 1995, 1996, 1997) argue that their three-factor asset pricing model is representative of equilibrium pricing models in the spirit of Merton's (1973) inter-temporal capital asset pricing model ICAPM or Ross's (1976) arbitrage pricing theory (APT) (FF, 1993, 1994, 1995, 1996). Such claims however are compromised by the observations of Lally (2004) that the FF (1997) loadings on the risk factors lead to outcomes that are contradictory with rational asset pricing. In response, we outline an approach to adjustment for leverage that leads by construction to compatibility of the FF three-factor model with the Modigliani and Miller propositions of rational pricing.

Keywords: leverage, asset pricing, CAPM, factor models, MM propositions

JEL Classification: G10, G12