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INTERDISCIPLINARY JOURNAL OF CONTEMPORARY RESEARCH IN BUSINESS
3.2 Theoretical Framework
Market risk Premium
Size Premium
Value Premium
3.3 Data Collection
This study aims to test the performance of Fama and French three factors model in KSE.
The sample consists of 20 companies from different sectors of economy and listed on the
stock exchange and the data of monthly stock returns is collected for the period of June
2004 to December 2008.
3.4 Data Analysis
Bull Bear
& Neutral
period
This study evaluates the ability of Fama French three-factor model to predict the returns
of companies listed in the Karachi Stock Exchange (KSE). The first part of the study
divides the four and a half year sample period of KSE into three categories namely, bull,
neutral and bear. These categories indicate the market condition prevalent in KSE in a
particular month. In the second part of the study, a sample of 20 companies from
different sectors of KSE were selected and combined to make a portfolio. Over a period
of four and a half years (June 2004- Dec 2008), the returns of the portfolio were
compared with the returns of KSE 100 index, which was assumed to represent market
returns in general.
In the next step, the selected portfolio was sorted according to company size and then
returns of smaller companies were compared with returns of bigger companies and
checked if it conformed to the claims of Fama French Model. The selected portfolio was
sorted according to the third factor of Fama French Model, which is book to market ratio.
Here again the returns of companies with high book to market ratio were compared with
returns of companies having low book to market ratio.
All the three factors were applied separately on the bull market period, neutral period and
bear period.
Mathematically, the FF model can be represented as:
Return
on KSE
Stocks
E[Rit ] ��R ft ��(E[Rmt ] ��R f )��i,1 ��(SMBt )��i,2 ��(HMLt )��i,3
Here E[Rit ] is the portfolio's return rate,
R ft is the risk-free return rate
E[Rit ] ��R f gives excess return on a security,
E[Rmt ] is the return of the KSE 100 index
E[Rmt ] – R f gives the risk premium
SMBt stands for "small [cap] minus big", it measures the historic excess returns of
small caps over big cap companies.
COPY RIGHT © 2011 Institute of Interdisciplinary Business Research 251
JANUARY 2011
VOL 2, NO 9