The validity of fama and french three factor model: evidence from the Nairobi securities exchange

Abstract

Since investment returns reflects the degree of risk involved in an investment, investors need to be able to determine how much of a return is appropriate for a given risk. A number of models have been used to determine this return such CAPM, APT and more recently the FF3F models. This study investigates the claim of the Fama and French three-factor model to be a “risk” model of stock price formation that is consistent with efficient market pricing. The study was performed at the NSE for the period spanning the period 2008–2012. The study provides some empirical evidence in an emerging market, the NSE. Multivariate regression analysis was applied on the nine portfolios made on the basis of size and book to market value. Monthly data of 60 companies were taken for the period of five years starting from January 2008 to December 2012. Estimation results show that the Fama and French three-factor model has a limited potential to explain variations on the return of portfolios which are constructed by using stocks operating on NSE during the years from 1st January 2008 to 31st December 2012. As was the case in the previous studies of Fama and French, the SMB slope(s) is higher for small stock portfolios than the others. They concluded the SMB captures the size effect in portfolio returns. However, big size portfolios and M/H portfolio have insignificant slopes. This means that size effect is not measured on big size and M/S portfolios. High minus Low (HML) is the risk factor capturing the book to market effect of stocks on average excess portfolio returns. Book-to-Market value is effective for high BE/ME stock portfolios but this effect is ambiguous meaning that BE/ME ratios effects average excess portfolio returns in an unsystematic and unambiguous manner. The study recommends that cost of capital estimates would be more accurate using a multiple factor model such as the four-factor model rather than the FF3F model; portfolio performance evaluation should take into account the size, BM and momentum effects; and the existence of size and BM return premia appear to rewards to risk bearing rather than due to market inefficiency.