Agooddissertation.docx
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Agooddissertation.docx
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Agooddissertation
TableofContents
Introduction5
1.1ResearchBackground.6
1.2ResearchAim6
1.3ResearchObjective7
1.4ResearchQuestions8
LiteratureReview9
2.1PriorEvidenceoftheFour-FactorModelintheUK13
2.2Hypotheses15
DataandMethodology17
3.1ResearchData17
3.2ResearchMethodology18
EmpiricalResultsandDiscussion21
4.1SummaryStatistics21
4.2DataAnalysis27
4.2.1FullSampleRegression27
4.2.1.1FullSampleAnalysis28
4.2.1.2GraphoftheFullSampleAnalysis30
4.2.2BullMarketRegression34
4.2.2.1BullMarketAnalysis35
4.2.3BearMarketRegression38
4.2.3.1BearMarketAnalysis39
4.2.4BehaviorFinanceArguments40
SummaryandConclusion42
5.1Recommendations43
References44
Appendices49
Table1:
SummaryStatistics21
Table2(a):
ExcessReturnsonthesixportfolios(FullSample)24
Table2(b):
ExcessReturnsonthesixportfolios(BearMarket)25
Table2(c):
ExcessReturnsonthesixportfolios(BullMarket)26
Table3:
Regressiononthesixportfolios(FullSample)27
Table4:
Regressiononthesixportfolios(BullMarket)34
Table5:
Regressiononthesixportfolios(BearMarket)38
Figure1:
MarketFactor30
Figure2:
SizeFactor31
Figure3:
Book-to-marketFactor32
Figure4:
MomentumFactor33
Picture1:
MarketReturn49
Picture2:
SMBReturn49
Picture3:
HMLReturn50
Picture4:
WMLReturn50
Acknowledgement
Abstract
Thispaper,westudythesignificanceofthefour-factorassetpricingmodel(marketfactor,sizefactor,book-to-marketfactorandmomentumfactor)inexplainingthecross-sectionalvariationinaveragestockreturnsintheUnitedKingdom.Ourfindingsshowthatthefour-factormodeldoesworkwellandsignificanttoexplainthecross-sectionalvariationinaveragestockreturnsforJuly2000toJune2007period.Ourempiricalfindingsindicatethatonaverageannualpremiumforthemarketfactor,sizefactor,book-to-marketfactorandmomentumfactorisminus3.64percent,5.20percent,3.12percentand26.52percent.Ourresultssuggestthatthesmallfirmsproducehigherreturnsthanbigfirms.Forthehighbook-to-marketequitystocksmorelikelytoperformhigherreturnsthanlowbook-to-marketequitystocks.SMBandHMLareproxyforsensitivitytoriskfactorsthatcapturecross-sectionalvariationinaveragestockreturns.Wealsofindthatthereisstatisticallysignificantinmomentumfactor.Moreover,weobservethatthefour-factormodelintheUKstockmarketworkswellinexplainingthevariationinthestockreturnsnomatterthemarketisgoingupordown.
1.0Introduction
In1970’s,(Sharpe1964),(Lintner1965)and(Black1972)introduceTheCapitalAssetPricingModel(CAPM)whichisthefirstassetpricingmodelinfinance.Thismodelhasbecomespopularinexplainingtherelationshipbetweenreturnandmarketbetaonriskyfinancialassets.AccordingtoCAPM,asthecapitalmarketinequilibrium,investors’willingnesstobearhigherrisktoobtainhigherexpectedreturn.Investorsfaceonlyonesourceofuncertaintywhichistheperformanceofthemarketasawhole.Theybearonlymarketrisk(marketbeta)andnootherriskfactor.Thereisalinear,positivelyslopedrelationshipunderriskandexpectedreturnonriskyfinancialassets,notedby(Sharpe1964).Inotherwords,theexpectedreturnofasecurityorportfolioisgreater,thegreateritsmarketrisk.
1.1ResearchBackground
However,recentempiricaltestsintheareaofassetpricingindicatethatthecross-sectionalofaveragestockreturnsdoesnothaverelationorlackofsupportiveevidencetothemarketbetaoftheCAPM.(FamaandFrench1992)statethatbetaisnearlyworthlessasanexplanationofastock’srelativeperformanceovertime.Theyshowthatstrategiesbasedoninvestinginstockswithsmallmarketequity(ME)andhighbook-to-marketequity(BE/ME)tendtoproducebetterlong-termperformancethanstrategiesbasedonmarketbeta.Ifstocksarepricedrationallyinstockmarket,thendifferentriskfactorsshouldabletoexplainsystematicdifferencesinaveragestockreturns.(FamaandFrench1993)developedathree-factorassetpricingmodelwhichincludestwoadditionalriskfactors–size(SMB)andbook-to-marketratio(HML)hasfoundtobesignificantlycorrelatedwithreturns.SMBisthethreesmallstockportfoliosaveragereturnsminusthethreebigstockportfoliosaveragereturn.HMListhetwohighbook-to-marketstockportfoliosaveragereturnsminusthetwolowbook-to-marketstockportfoliosaveragereturns.EmpiricalstudiesshowthatthreefactormodelhasbeentestedandconfirmhashighexplanatorypowerthanonefactorCAPM.Therefore,theFamaandFrenchthree-factormodelseemstobecomeapopularassetpricingmodelcomparetotheCAPMinfinance.(FamaandFrench1995)attempttotestthethreefactormodeltowardfundamentalsshock(earningsandsales).TheyfindthattheFamaandFrenchthree-factormodelhashighexplanatorypowerinrelationtothebehaviorofearnings.However,theyshowthattheirresultsareweakbecausethereislackofsupportiveevidencetoconfirmreturnsrespondtothebook-to-marketfactorinearnings.(FamaandFrench1993)arguethatthethree-factormodelcancapturethecross-sectionalvariationofthestockreturnsexceptmomentumeffect.(JegadeeshandTitman1993)and(Carhart1997)indicatethatmomentumfactoralsoanotherriskfactorwhichcancapturethecross-sectionalvariationofthestockreturns.Theydocumentthatstockswithhighreturnsoverthepasttwelvemonthscontinuetoperformwellcomparetostockswithlowreturnstendtoperformpooroverthesametime.(Carhart1997)constructsafour-factormodelbycombinetheFamaandFrenchthreefactorwithmomentumfactorasadditionalriskfactor.Hefindsthatthefour-factormodelcapabletoexplainpersistenceinequitymutualfundperformance.TherobustnessofmultifactorassetpricingmodelworkswellinexplainingrealizedreturnsfortheUSportfolios.Inrecentyears,manyempiricalstudieshavebeentestedoutsidetheUSportfolios.Forinstance,(Chan,HamaoandLakonishok1991)indicatethat“fundamental”variables(size,book-to-marketratios,earningsyieldandcashflowyield)capturethecross-sectionaldifferencesinreturnsonJapanesestocks.(Chan,KarceskiandLakonishok1998)findthattheperformanceofsizefactorandbook-to-marketfactorworkwellincapturingthecovarianceintheUKstockreturns.(Morelli2007)alsoexaminestheFamaandFrenchthree-factormodelfortheperiod1980to2000andfindsthatmarketreturnandbook-to-marketpremiuminexplainingthecross-sectionalrealizedreturnsinup(Bull)anddown(Bear)markets.However,hestatesthatthereisinsignificantexplanatorypowerforsizefactorinupanddownmarkets.OtherrecentempiricalevidenceintheUKdoneby(GregoryandMichou2009)pointoutthattheSMBandHMLfactorslopesshowconsiderablevariabilitythroughtimeexceptmomentumfactor.TheirfindingsareconsistentwithFamaandFrenchthree-factormodelempiricalresultswhichpresentmomentumfactorcannotcapturecross-sectionalvariationinaveragestockreturns.Insummary,therehasbeenverylimitedresearchonthefour-factormodelrelatingtotheUKstockmarket.Evidenceofthefour-factormodelintheUKstockmarkethasbeeninconsistentandmixfindings.
1.2ResearchAim
Inthisstudy,wefindthatthereisnotsufficientamountofempiricalstudiesregardingthefour-factormodelintheUK.Therefore,examiningtheeffectivenessofthisassetpricingmodelisassumedcrucial.Thisstudyaim,wewanttotestthefeasibilityoftherobustnessfour-factormodelforthestockstradedontheLondonStockExchange(LSE)duringJuly2000toJune2007.Inotherwords,wewanttoinvestigatewhetherotherriskfactors(sizeeffect,book-to-marketeffectandmomentumeffect)besidesmarketbetaarealsoexplanatoryvariablesofthevariationinaveragereturnsintheUKstockmarket.MostoftheempiricalstudieshasfocusedontheUSportfolios,if(FamaandFrench1998)findingsfortheUSportfolioscapabletoconfirmoutsidetheUSmarket,thenweassumeourresultscancontributetobothindividualandinstitutionalinvestorswhocanformtheiroptimalportfoliosaccordingtothesignificantmeasuresintheUK.Forexample,(FamaandFrench1996)statethatsizepremiumandvaluepremiumhaveastrongexplanatorypowertothecross-sectionalinaveragestockreturns.Therefore,webelievethatwithabetterandaccuratebenchmark,individualorinstitutionalinvestorsabletoconstructtheirportfoliosbasedontheseriskfactorsandestimatetheirexpectedstockreturns.Anothermotivationforthispaperisthatweinvestigateforthe(Carhart1997)four-factormodelbyaddingamomentumfactorintotheFamaandFrenchthree-factormodel.Wewanttoexaminewhethermomentumriskcantakesaccountofthefactthatpaststockpriceswillhaveasignificantimpactonthereturnsmade.Thereislimiteddocumentingforexaminethefour-factormodelintheUKstockmarket.Therefore,wesuggestouranalysisresultscangivevaluableinformationtoindividualorinstitutionalinvestorsforinvestmentpurposesorfutureresearchintheUKstockmarket.
1.3ResearchObjectives
Inthisstudy,ourpaperhasdifferentfromotherresearchpaperswhichinvestigatethefour-factormodelintheUK.First,ourdatacollectioncontainshighlycapitalisedcompanyfromFinancialTimesStockExchange(FTSE100)listedontheLondonStockExchange.Weusetherecentsampleperiods(2000-2007)whichcanhelpustotestthefour-factormodelwithmostrecentpastreturnsdata.Anotherpointismostoftheempiricalevidences
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