Please look at the attached picture a) (5 points) Does the Fama-French 3-factor
ID: 2664052 • Letter: P
Question
Please look at the attached picture
a) (5 points) Does the Fama-French 3-factor model explain the variation in the portfolio A returns? Explain your answer.
Assume that you collect data on the returns of portfolio A over the period 1960-2010. Next, you run the Fama-French 3-factor model regressions using these returns. You obtain the following estimates: Please look at the attached picture a) (5 points) Does the Fama-French 3-factor model explain the variation in the portfolio A returns? Explain your answer.
Explanation / Answer
No it couldn’t explain the variation in the portfolio A returns. Fama-French three-factor model, Fama and French run the regressions of excess asset return on excess market return R jt – R ft = Alpha j + ß j (Rmt – Rft) + sj SMBt + hj HMLt + ejt ? Where as, Rjt is the rate of return on asset or portfolio j at time t ? Rft is the risk free rate of interest at time t ? Rmt is the rate of return on the market portfolio at time t ? SMBt (small minus big) is the difference of the return on small and big assets at time t ? HMLt (high minus low) is the difference of the returns on high and low book-to-market equity ratio (BE/ME) assets (or) portfolios at time t. ? Betas are the factor sensitivities of the state variables. Fama-French three-factor model is a well-known model and there is a long list of research papers supported the model even though the CAPM is dominated by the three-factor model. In Fama and French (1960), they do not report the intercept and do not use the GRS test. They only state the average slope of SMB and HML are useful as the majority of t-statistics from 25 time series regressions are high. Hence, we understood the CAPM is better than the three-factor model, if the average absolute pricing error test is used. Here, in this case the Fama-French adjusted to t-statistics of the intercepts give mixed results. If the Fama-French adjusted t-statistics of the slopes in the cross-sectional regressions are compared, the three-factor model has explanatory power but the CAPM has not.