Implementing the three factor model of Fama and French on Kuwait's equity market
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Date
2009-12
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The British University in Dubai (BUiD)
Abstract
Asset Pricing Theory addresses the relationship of security return with security risk which is caused by the unknown possibility of returns. Determining the correct and accurate expected returns has been the major concern surrounding Asset Pricing Theory.
For almost half a century, the Capital Asset Pricing Model, Sharpe (1964), Linter (1965) and Mossin (1966), has been the corner stone for determining the asset risk/return relationship. It relies on beta known as the systematic risk in determining returns. However in the 1980’s, criticism arose, which caused empirical researchers and financial practitioners to move away from the so known model. Miller (1999) and many professionals came to agree that the CAPM is no longer a sufficient model to explain the cross section of average returns. A recent alternative was introduced by the work of Fama and French (1993) who brought around two additional risk proxies not shown in the CAPM, one is the small size factor, indicating that smaller firms on average earned more than bigger firms and second book to market equity, demonstrating that firms with higher book to market ratios earn more than firms with lower book to market ratios. The two factors experienced abnormal returns that were not captured by CAPM’s beta.
Looking briefly at some of the literature of Fama and French, their (1992) paper proved that security risk is associated with firm size as well as book to market equity. In 1993, they examined a time series approach to their work that was not apparent in their earlier paper. In 1995, their work confirms that book to market equity and size proxy for the sensitivity of the risk factor that explains stocks returns, and secondly that size and book to market equity are explained by profitability and the earnings behavior. In 1996, Fama and French prove that many of CAPM’s anomalies disappear when using their multi index model. Fama and French (1998) discovered that value and small cap stocks earn higher returns for the majority countries under their examination.
In this study the Fama and French (1993) model is tested in Kuwait’s market from years 2000-2007. There are two main objectives, first to extend the Fama and French model internationally, to Kuwait, to see whether or not the additional factors of book to market equity and size proxy for risk that help explain stocks returns. Secondly, this study addresses Fama and French’s main controversies. It aims to address the vast majority of practitioners that believe beta alone is sufficed in explaining security returns. In addition, aims from the need to expand Asset Pricing Theorywork internationally as most of their work is conducted in the U.S. Moreover, there is an important need to provide investors a clearer understanding of asset pricing anomalies that can exist. The anomalies discovered by Fama and French defies the whole generation of investors that believe in efficient markets and that asset returns are a result of volatility. Finally,
this study aims at shedding more light into the area of asset pricing models in Kuwait; its
importance serves many functions such as capital budgeting, security evaluations and investment performance and evaluations.
Four portfolios were constructed, (S/L) small cap stocks along with low book to market firms, (S/H) firms that are small in size with high book to market firms, (B/L) big firms with low book to market firms, and (B/H) big firms with high book to market ratios. The returns of the above portfolios are regressed on the market portfolio, a mimicking portfolio capturing the average difference between returns of small firms and the return of big firms and third a mimicking portfolio which captures an equally weighted long position in high book to market portfolio and an equally weighted short position on low book to market ration.
Kuwait’s results indicated that the Fama and French model added a marginal effect in pricing securities and especially for those securities that are in the S/L and S/H categories. In addition to finding premiums for small and high book to market firms, our results dismiss most of Fama and French’s controversies. Lakonishok and Vishnay (1994) theory has been disproved since our findings confirm that high book to market premium is not a result of an arbitrage opportunity. We also responded to the ‘Survivorship Bias’ argument by Kothari, Shanken and Sloan (1995) by testing both the firms that failed as well as firms that survived, unlike Fama and French were
only the surviving firms were tested, our results thus do not support the ‘Survivorship Bias’
theory. Responding to the ‘Datasnooping’ argument by Lo Mackinlay (1988), Black (1993) and Mackinlay (1995) also took place when testing in an out of sample test as in our example, Kuwait. The only controversy of Fama and French that could not be tested was Daniel and Titman (1997) since we were limited with data to construct portfolios with many different variations in characteristics and factor loadings. Results in Kuwait refute the Efficient Market Theory Hypothesis since our finding confirm that returns are not related to volatility and secondly that Multi Factor Minimum Variance MMV portfolios were discovered that negates the market factor as the only Minimum Variance Efficient MVE portfolio.
Overall Kuwait’s results proved that a multifactor model is more explanatory than the CAPM’s beta. This of course has many implications especially in calculating cost of capital and in evaluating portfolio managers. Results though were not as powerful as the model exhibited in the U.S and in some international markets. Reasons might be because of the smaller time period of study in Kuwait, 8 years in comparison to 70 years in the U.S. A second reason might because of the many new joining companies in years 2003-2004 in Kuwait; which negates the possibility of revealing a small and book to market premiums, as these need more time to become obvious.
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DISSERTATION WITH DISTINCTION
Keywords
three factor model, equity market, Kuwait, asset pricing theory, Fama and French