Evaluation of Efficiency and Explanatory Power of the CAPM and the Fama-French Asset Pricing Models: Evidence from the U.S. Equity Markets

Abstract

CAPM model it is a linear relation between the risk, that is Beta and expected return from assets. This model assumes that it is possible to achievement high return from assets, if β is proportionally high. Additionally β is an only factor of the risk measure (Harry and Markowitz, 1952). However, there are many works which undermine the effectiveness of the CAPM. Fama & French (1992) conducted non-financial research of companies from period 1963 to 1990 US Stock Market, but didn't found the connection between beta and Stock return. Therefore, Fama & French (1993) inspired by previous studies created the Fama & French three factor model, which how authors research confirm: Daniel and Titman (1997), Drew and Veeraraghavan (2003) as well as Faff (2004) in the precise manner predicts and explains changes of the pace stock return. The specificity of this model consists on examining the sensitivity of three factors Fama French model to examine whether the return from portfolio may exceed return from investment risk-free e.g. T-bill. Above all focuses on the surplus of income from market as a whole, and SMB understood as differences from returns portfolio Small Stock and High Stock as well as the third HML factor, i.e. difference between portfolio of high-book-to-market stocks and small-book-to-market stocks. Therefore in order to estimate beta for each of described above factors, simple regression is used as well as estimated values are multiplied by risk premium for the individual factor. In such a result, we will receive estimated values for the given portfolio or its price. Petkova (2006) examined the sensitivity of SMB factors and HML on the example data from period 1963-2001. He examined, that these factors correlated positively explain the time-series variation concerning stocks rate of return, however better results achieved ICAPM while explaining cross-section return. It is evidence of continued development of new research. In this work examines the behavior of the Fama French model during various stages of market growth and decline. Research performed using daily trading the S&P 500. Addition was tested the power of explanation the Fama French Model on the basis of 12 industrial portfolio of U.S. market. The data obtained are contrasted with the results of the effectiveness of CAPM conducted in the same manner.

Keywords: CAPM, Fama-French model, S&P 500