1. FAMA-FRENCH MODEL Concept and Application

2. Learning Objectives Concept of Fama and French model
Concept of three risk factors in the model
The interpretation of the model
The pros and cons of the model
8 steps to use the Fama and French model
An empirical study in UK market

3. Fama and French Literature on Factor Models
An alternative asset pricing model to CAPM
Three risk factors affecting asset expected return (Fama and French, 1993)
Market risk premium
Size effect or size premium
Book-to-Market value effect or value premium

4. Model/ Formula (Fama-French, 1993)
Rit – Rft = αit + βiM (RMt - Rft) + βisSMBt + βihHMLt + εit
Rit is the total return of individual stock/portfolio i Rft is the risk free asset return RMt is the total market portfolio return Rit – Rft is expected excess return RMt - Rft is the excess return on a market portfolio index SMBt is the size premium HMLt is the value premium

5. Steps for Fama-French, 1993 Step 1: Collecting data
Step 2: Construct portfolios formed on Size and value
Step 3: Calculate average returns of each portfolio
Step 4: calculate SMB
Step 5: Calculate HML
Step 6: Calculate Rit – Rft
Step 7: Calculate RMt - Rft
Step 8: Running multiple regression

6. STEP 1: Collecting data Book-to-market ratio (BE/ME)
Market Capitalization (Market Cap)
Monthly stock price including dividend
Risk free rate of return (Rf): short-date Treasury Bills
Market Return (Rm): monthly market index return

7. STEP 2: Construction of six Portfolio
S/L
Represented the group of portfolio that have a small size and low book-to-market value
S/M
Represented the group of portfolio that have a small size and medium book-to-market value
S/H
Represented the group of portfolio that have a small size and high book-to-market value
B/L
Represented the group of portfolio that have a big size and low book-to-market value
B/M
Represented the group of portfolio that have a big size and medium book-to-market value
B/H
Represented the group of portfolio that have a big size and high book-to-market value

8. Step 3: Calculate average returns of each portfolio
Calculate the average return of each observed stock
Calculate the average return of six constructed portfolios

9. Step 4: Calculate SMB Based on the formula:
SMB= 1/3(Small Low + Small Medium + Small High) – 1/3(Big Low + Big Medium + Big High)

10. HML= ½(Small High + Big High) – ½ (Small Low + Big Low)
Step 5: Calculate HML
Based on the formula:
HML= ½(Small High + Big High) – ½ (Small Low + Big Low)

11. Step 6: Calculate Rit – Rft
Calculating stock return (Rit)
Subtracting risk free rate of return from average return of each portfolio
Rit= 𝑃 𝑖 − 𝑃 𝑖−1 𝑃 𝑖−1
(Rit x 100 – Rft x 100)

12. Step 7: Calculating Rmt – Rft
Calculating Market return (Rmt)
Subtracting risk free rate of return from market return
Rmt= 𝑃 𝑖 − 𝑃 𝑖−1 𝑃 𝑖−1
(Rmt x 100 – Rft x 100)

13. Step 8: Running multiple regression
Diagnostic tests (Nonstationary, Autocorrelation, Heteroscedasticity and Multicollinearity)
Running multiple regression for one dependent (Rit – Rft) and three independent variables (Rmt – Rft), SMB and HML).
Could use Excel or SPSS or Eviews software.

14. An Application using UK FTSE100 Data
London Stock Exchange FTSE100
Period:
Monthly data
Times series multiple regression test
Sample: 94 stocks
SEE EXCEL FILE

15. Thank you