A thesis
submitted in partial fulfilment
of the requirements for the Degree of
Master of Commerce and Management
At
Lincoln University
by
Liu Yaoguang
Lincoln University
2009
Abstract
This research attempts to test the performance of the Fama-French three-factor model (1993) in explaining the stock portfolio returns on the China A-share Stock Market from 1996 to 2005. In this study, the data are obtained from Chinese stock Market and Accounting Research database. We will follows Drew, Naughton and Veeraraghavan (2003) method, who adopted the Fama and French's (1993) method to test small sample stock markets. We find the positive relation between book-to-market ratio and stock excess returns, and the negative relationship between size and stock excess returns. And our result demonstrated that the three-factor model is more accurate in predicting stock excess returns than the CAPM, since the adjusted R-Square value increased and the intercept are not significantly different from zero. The size effect is stronger than the BTM ratio effect. Moreover, our results present that stock profitability is related to size and BTM ratio in China stock market. However, the relationship between stock profitability and size and BTM ratio are unconditional.
Key words: Asset pricing; cross-section; three-factor; firm size; book-to-market; Chinese A- share
Introduction
Financial researchers have attempted to develop robust and meaningful asset pricing models for investors to value asset returns. This includes the traditional Capital Asset Pricing Model (CAPM). However, empirical researchers have pointed out that the CAPM could not explain the portfolio stock returns accurately, and some researchers employed other models to predict portfolio stock returns. For example, Fama and French (1993) used the three-factor model to explain the portfolio stock expected returns and reported that the CAPM had weak explanatory power in predicting asset returns.
The CAPM, developed by Sharpe (1964), Lintner (1965) and Black (1972), is widely used by portfolio managers, institutional investors, financial managers, and individual investors to predict asset returns. Beta is used to measure the systematic risk in the CAPM model and is assumed to be positively related to asset returns. However, several researchers have demonstrated that other variables exist that could significantly explain the expected asset returns and the beta showed either no relationship or a weak relationship with the expected asset returns. Roll (1977) argued that the CAPM is not testable because the test involved a joint hypothesis on the model and the choice of the market portfolio. According to Roll, the real proxies would be highly correlated with each other. The linear relationship between assets return and beta is based solely on the mean-variance-efficient hypothesis of market portfolio, but the real market portfolio did not support the mean-variance-efficient hypothesis.
Researchers have identified several factors that could affect asset returns, such as firm size (Banz, 1981; Reinganum, 1981, 1982; Keim, 1983; Fama and French, 1992, 1993, 1995, 1996), and book-to-market equity (BTM) ratio (Stattman 1980 and Chan, Hamao and Lakonishok 1991). For example, Banz (1981) discovered that small firms’ average returns were higher than large firms’ average returns on the New York Stock Exchange from 1926 to 1975. The author’s results showed that firm size affected the stock return but the earning price (EP) ratio could not explain the stock returns. Keim (1983) reported that the relationship between size and stock returns was significantly negative and that small firms which earned high returns could be caused by the January effect.
Some studies also indicated that the asset returns might be affected by the book-to-market equity ratio and argued that the BTM ratio is positively related to stock returns. For example, Stattman (1980) reported a positive relationship between expected stock returns and the BTM ratio in the U.S. stock market. Chan et al.’s (1991) study showed a significant positive relationship between the BTM ratio and expected asset returns from 1971 to 1988 in the Japanese stock market. However, Chen and Zhang (1998) pointed out that the spread of risk is small between the high and low BTM ratio stocks in high growth markets such as Taiwan and Thailand. Lakonishok, Shleifer and Vishny (1994) advocated that the BTM ratio effect was due to market overreaction to the firm’s prospects. Other researchers such as Keim (1990) reported that there is a positive relationship between the expected returns and EP ratio, and Bhandari’s (1988) study revealed a positive relationship between debt to equity (DE) ratio and stock returns.
Fama and French Three-factor Model
Fama and French (1992) examined the relationship between five factors (beta, firm size, BTM ratio, DE ratio and EP ratio) and cross-sectional stock returns on the U.S. stock market.
According to the authors, the BTM ratio effect could absorb the DE effect and the relationship between EP ratio and cross-sectional stock returns could be subsumed by a combination of firm size and the BTM ratio. Fama and French concluded that the beta did not have a significant role in explaining stock returns, including in the long run and firm size, and the BTM ratio was sufficient to explain the variation in stock returns.
Fama and French (1993) presented the three-factor model, where firm size and the BTM ratio were included, together with the market beta as the third factor. The authors argued that the new model could explain the cross-sectional stock returns better than the CAPM. Fama and French contended that firm size and BTM ratio could explain the cross-sectional variation on the U.S. stock markets sufficiently, and firm size and the BTM ratio could be proxies for risk.
Research Objective
There are three research objectives in this study. The first research objective is to test whether there are firm size and the BTM ratio effects in the Chinese A-share stock market. Drew, Naughton and Veeraraghavan (2003), Wang and Xu (2004) and Wong, Tan and Liu (2006) found that the firm size was negatively related to stock returns in the Chinese stock markets. However, the authors argued that there was no BTM ratio effect in the Chinese stock markets. On the other hand, Chen, Kan and Anderson (2007) tested the risk factors on the Chinese stock markets and reported a positive relationship between the BTM ratio and stock returns. Wang and Iorio (2007) conducted a similar test using the Fama and French (1992) model on the Chinese A-share stock market and confirmed the presence of firm size and BTM ratio effects. This study follows the Drew et al. (2003) framework to re-examine the size and book- to-market effect on the Chinese A-share stock market.
The second research objective is to test whether the Fama and French (1993) three-factor model is applicable to the Chinese A-share stock market and whether the Fama and French model could present a better explanation for stock returns than the CAPM on the Chinese A- share stock market. Drew et al. (2003) indicated that the CAPM could not adequately measure the stock returns in the Shanghai stock market. Wang and Iorio (2007), in their analysis, found that neither the local beta nor the global beta was related to the Chinese A-share stock return. There is no research that examines the application of the original Fama and French (1993) three-factor on the Chinese A-share stock market. Thus, this study will test the applicability of the Fama and French three-factor model to the Chinese A-share stock market and will compare the performance of the three-factor model and the CAPM.
The third research objective is to find out whether there exists size and BTM ratio factors in the stocks’ earnings. Fama and French (1995) claimed a fundamental economic reason for the firm size and BTM ratio effect on the stock returns. The authors reported that the size and BTM ratio were related to stocks’ profitability. The high-BTM ratio stocks were less profitable compared with the low-BTM ratio stocks, and small stocks had lower earning to book value ratio than large stocks. In this study, we follow Fama and French’s (1995) method to find out the economic reason for the size and BTM ratio effect by using Chinese A-share stock market data.
Significance of Research
Most of the research testing the Fama and French (1993) three-factor model concentrated on the U.S. stock markets. Although there is evidence to support the three-factor model using data from stock markets outside the U.S., there is a lack of empirical evidence to tell whether there are firm size and BTM ratio effects on the Chinese A-share stock market. Several studies have investigated the Chinese stock markets using the Fama and French three-factor model. They include Drew et al. (2003) and Wong, Tan and Liu (2006). These studies found that there was a size effect in the Chinese stock markets, but the BTM ratio had weak explanatory power in the cross-sectional stock returns. Wang and Xu (2004) tested the stock returns in the Chinese A-share stock market including the Shanghai and Shenzhen A-share stock markets. Their results showed the BTM ratio had no effect in the Chinese stock markets.
On the other hand, Wang and Iorio (2007) and Chen, Kan and Anderson (2007) used different methods to examine the risk factors related to stock returns in China and found that the firm size and BTM ratio could be risk factors for stock returns in the Chinese stock markets. In summary, some empirical studies showed a BTM ratio effect in the Chinese stock markets, but there is no direct evidence to support the Fama and French three-factor in the Chinese stock markets.
The CAPM is widely used to predict asset expected returns by both researchers and practitioners in various situations, such as portfolio management, evaluation of asset performance, and capital budgeting. If the CAPM inaccurately predicts stock returns, it will result in sub-optimal resource allocation decisions and negatively affect the investors’ wealth. Our study will show that the Fama and French (1993) three-factor model can better explain the stocks returns than the CAPM model in the Chinese A-share stock market. The findings of this research can help investors to select their investment portfolio and supply the benchmark model to evaluate the stock portfolio returns and the cost of the capital.
Previous research which tested the stock returns on the Chinese stock markets used data from 1993 to 2002 (see Drew et al. 2003; Wang and Xu, 2004; Wang and Iorio, 2007; Wong et al. 2006). However, the Chinese stock markets had many deficiencies at the beginning. For example, the market standardisations were inadequate and there were still significant regulatory loopholes (see Lee, Chen and Rui 2001). These deficiencies could affect the stock returns and may cause bias and inaccuracy in the testing models. Our study testing period is from 1996 to 2005, when the standards and regulatory framework of the stock market was more mature, the market was more efficient, and the stocks were not mispriced. Therefore, there were fewer arbitrage opportunities for arbitragers, the data are more reliable and the results will be more robust in predicting stock returns than in prior studies.
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