Application of the Fama and French Three-Factor-Model to the Greek Stock Market

Georgios Maris

THESIS SUBMITTED IN PARTIAL FULFILLMENT OF THE

REQUIREMENTS FOR THE DEGREE OF

MASTER OF SCIENCE

in the

Department of Accounting & Finance

UNIVERSITY OF MACEDONIA

Autumn 2009

ABSTRACT

This thesis investigates the robustness of the Fama and French Three-Factor- Model on the Greek stock market for the period July 1999 to June 2009. It continues the out of sample tests of the model conducted by Malin and Veeraraghavan (2004). The test follows the time series regression approach of Black, Jensen and Scholes (1972). Monthly portfolio returns are regressed on three factors (market, size, BE/ME ratio). We document negative excess market returns probably because of the two major bear market rallies that took place in the beginning and in the ending of the sample period. We also find a big firm effect in contrast to Fama and French (1996) and Malin and Veeraraghavan (2004) who observe small firm effects. Finally, we observe a value effect that is consistent with Fama and French (1996) findings in the U.S. market. However, the portfolios constructed under this model have insignificant market, size and value premia, a finding that seriously questions the validity of the model in the Greek market. In addition, diagnostic tests of the model reveal serious flaws that should be addressed before reaching safe conclusions. Further testing across sub-periods should be conducted in order to check parameter stability because there are many indications that structural breaks have taken place during the sample period. For the time being we suggest the model not to be used for making investment decisions in the Greek stock market.

INTRODUCTION

An investor is faced with a choice from among an enormous number of assets. When one considers the number of possible assets and the various possible proportions in which each can be held, the decision process seems overwhelming. Fortunately, there are basic principles underlying rational portfolio choice that help decision makers to structure their problems in such a way, that they are left with a manageable number of alternatives (Elton et al: 2007).

All decision problems have common elements. They all involve the delineation of alternatives, the selection of criteria for choosing among those alternatives and the solution of the problem. Furthermore, individual solutions can often be aggregated to describe equilibrium conditions that prevail in the marketplace. Under certainty, these problems become simple. One has to define investor’s opportunity set and indifference curves in order to reach a solution. Constrained optimization is a sufficient tool to solve investment problems under certainty. However, uncertainty does exist in the real world. Asset pricing theory tries to understand the prices or values of claims to uncertain payments. To value an asset in an uncertain world, we have to account not only for the delay (time value of money) but also for the risk of its payments. Corrections for risk are very important determinants of many assets’ values (Cochrane: 2005). The existence of risk means that the investor can no longer associate a single number or payoff with investment in any asset. The payoff must be described by a set of outcomes and each of their associated probability of occurrence, called a return distribution. The two most frequently employed attributes of such a distribution are expected return and standard deviation.

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