Abstract
CAPM has been prevalently used by practitioners for calculating required rate of return despite having drawbacks. Fama French presented their 3 factor model in order to gap the limitations posed by CAPM model. This paper attempts to examine practical implications and effectiveness of Fama French model vis-a-vis the CAPM model in explaining excess return of Dhaka Stock Exchange by analyzing five publicly listed firms of Cement industry over 10 years period of 2004-2014. As the representative of market index, DGEN is taken from 2004 till 2013 and later on DSEX is taken. Simple and multiple linear regression analysis have been used against daily market return and respective companies return. Results shows that adjusted R square of Fama French model have a higher value than adjusted R square of CAPM model after running cross sectional regression of the observed panel data. It means that Fama French model is better predicting variation in excess return over Rf than CAPM for all the five companies of the Cement industry over the period of ten years. Low p values indicate that the coefficients are statistically significant. Nonetheless this paper concludes that the companies who want to use Fama French model instead of CAPM must evaluate the time and effort required to use the model before they replace CAPM with the multi factor model for their stock return analysis.
Highlights
After the famous Portfolio Theory of Markowitz, many researchers have come up with different theories aiming to explain excess portfolio returns
The authors argue that anomalies related to the CAPM are better captured by their three factor model. (Fama & French, Common risk factors in the returns on stocks and bonds, 1993) Fama French has tried to overcome the drawbacks of the CAPM but their original three factor model possess some limitations as well
The regression results from the above mentioned table indicates that Fama-French model can better explain the variability in the stock return for companies in the cement industry than that by CAPM model
Summary
After the famous Portfolio Theory of Markowitz, many researchers have come up with different theories aiming to explain excess portfolio returns. One of the ground breaking models is the CAPM which was established by Sharpe (1964) and Lintner (1965) which is still used prevalently in order to calculate cost of equity and determine asset pricing. This seminal theory is based on only one risk factor which is systematic risk. (Fama & French, Common risk factors in the returns on stocks and bonds, 1993) Fama French has tried to overcome the drawbacks of the CAPM but their original three factor model possess some limitations as well.
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