The objective of this paper is to construct and analyse the Fama and French three-factor model for the UK market. We will then be comparing the three-factor model to the slightly modified; Fama-French and Carhart’s four-factor model. The purpose of this paper is to find evidence, if any, of the validity of these multifactor models in the UK market. Previous research suggests that the search for a more convincing asset pricing model remains (Gregory, Tharyan and Christidis, 2011).
Keywords: Multifactor models, Fama-French model, CAPM, UK market, asset pricing
1. Introduction
Financial decisions revolve around estimations of expected return or cost of equity for individual stocks. Decisions that relate to portfolio management, performance …show more content…
He finds positive values for the estimated premiums for the book-to-market and emphasizes that the results relate to the negative size risk premium in his sample. The validity of Fama and French three-factor model and the Capital Asset Pricing Model (CAPM) was tested by Gaunt (2004) and his results come to show that the Fama and French three-factor model provides a stronger explanation of the Australian stock returns than the CAPM does. Griffin and Lemon (2002) carried out a study to determine whether Fama and French three-factor model was global or country specific. Monthly data was used for 1521 Japanese companies, 1234 UK companies, and 631 Canadian companies from 1981 to 1995. The findings suggested that Fama and French three-factor model performs best on a country specific …show more content…
Regional versions of the models provided a better description of the average return in portfolios which consider size and value. These models generally output a more sensible description of returns than global models. Explanations for this may include factors such as different exposures to macroeconomic factors or different accounting procedures which affect the book values. Therefore, if a regional model outperforms a global model, then we expect a country specific model to perform better than the regional and global model. By concentrating on a country, we eliminate any errors caused by foreign accounting treatments and foreign macroeconomic factors. A study carried out by J. M Griffin (2001) state that country specific Fama-French three-factor models outperforms both regional and global models. The paper also suggests that performance measures, risk analysis and cost of capital calculations using “Fama and French-style models” are best carried out at a country-level.
Cremers, Petajito and Zitzewitz (2010) (referred to from henceforth as CPZ) argue that we should construct the Fama-French factors by value-weighting the individual components rather than equal-weighting. We also construct one decomposed model in accordance with Zhang (2008). We have carried out similar tests as Gregory, Tharyan and Christidis (2011), whom tested six