Are Fama-French and Momentum Factors Really Priced?

Abstract

This paper investigates whether the existence of pricing anomalies represents compensation for bearing extra-market risks by directly testing a version of Merton's (1973) Intertemporal CAPM (ICAPM), allowing for both time-varying first and second moments of asset returns. The conditional ICAPM is estimated using multivariate GARCH in mean (MGARCH-M) modeling strategy, and then is used to examine three popular anomalies - size, book-to-market, and momentum. The results indicate that all the four risk factors (market portfolio (MKT), size portfolio (SMB), book-to-market portfolio (HML), and momentum portfolio (UMD)) are not only significantly priced, but also time-varying. The empirical results documented in this study provide a strong support of risk-based explanations for the anomalies. That is, the apparent high average returns represent compensation for bearing extra-market risks, which are not captured by the CAPM. The results also shed a new light on how the momentum effect should be interpreted since previous studies fail to detect a priced momentum factor in addition to book-to-market factor. Furthermore, because the ICAPM estimated in this study is fully parameterized, I am able to decompose the total time-varying risk premia into four components: market, size, book-to-market, and momentum. Among those four component risk premia, the market risk premium is the dominant one in describing the return dynamics of portfolios sorted based on the size, book-to-market, and industry.

Keywords: Pricing anomaly, ICAPM, Time-varying risk premium, Multivariate GARCH-M

JEL Classification: C32, G12