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Course Work Econometrics Essay

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Predicting Risk and Return Using CAPM and Fama-French (Three Factor Model): Empirical Evidence Based on the S&P 500 index
Team Alpha Jeroen Boersma -13045 Julio Medrano -13022 Marianne Brackel -13078 MSc Finance - Financial Markets & Regulation LLM Finance & Law Duisenberg School of Finance November 1st 2013

ABSTRACT This paper analyses the predictive accuracy of the CAPM and Fama-French on risk and return by using empirical evidence based on the S&P 500 index. The research is conducted using a two stage regression for the CAPM and a multifactor analysis on three portfolios using the factors imposed by Fama-French. The results give rise to the thought that a multifactor model, with the incorporation of additional factors explaining returns, better predict returns to the contrast of a single factor or CAPM model.

TABLE OF CONTENTS 1. Introduction 2. Literature Review 2.1 Capital Asset Pricing Model (CAPM) 2.2 Disadvantages CAPM 2.3 Fama-Frech (three-factor model) 2.4 Disadvantages three-factor model 2.5 General Implications 3. Methodology & Sample 3.1 Data Collection 3.2 Variables 3.3 Data Analysis Methodology 3.4 Hypotheses 4. Regression Results/Analyses 4.1 Sample Summary Statistics 4.2 Outcome Regressions 5. Conclusions 6. Bibliography 17 18 3 5




1 INTRODUCTION Imagine a financial sector in which we could perfectly define risk and return. Financial markets would change drastically. In the past, many scholars have attempted to estimate risk and return by establishing predictive models. The capital asset pricing model (CAPM) marked the birth of asset pricing models, as suggested by several authors inclusive of Fama and French (2004). Initially drawn from the portfolio theory developed by Markowitz (1959), the CAPM predicts that a market portfolio of invested wealth is mean-variance efficient and results in a linear cross-sectional relationship between mean excess returns and exposures to the market factor (Fama and French, 1992)....

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