Abstract
In order to explain the relationship between risk and expected return, different researchers use different asset pricing models. In this research paper, we identify whether Sharpe's single factor model termed Capital Asset Pricing Model or Fama-French three-factor model better explains the expected excess return on portfolio. We used NIFTY INDEX as the proxy market portfolio. For the purpose of FF Model, we used Market Capitalization (MC) as a variable of firm size and Book to Price (B/P) as a variable of firm value. Data are taken from 1<sup>st</sup> July 2012 to 30<sup>th</sup> June 2021 for 85 companies forming part of NSE 100. We have used the same portfolio selection framework used by Fama-French (1993 and 1996). 91 days treasury bills (T-bills) have been used as risk-free proxy and taken from RBI website for the given period. We found that Fama-French three-factor model captured better results than the single factor CAPM in explaining the expected returns for all the double-sorted portfolios constructed based on MC (size factor) and B/P (value factor).
Highlights
The capital asset pricing model (CAPM) of Sharpe (1964), Lintner (1965) and Mossin (1966), based on pathbreaking work of Markowitz (1952) is the backbone of the current portfolio philosophy
We find that the expected return of the portfolios classified by Market Capitalization (MC) and Book to Price (B/P) can be explained by comparing the two asset pricing models, the CAPM and the FF3F
To estimate the CAPM in its best way, we look at the excess return version of market factor model and expect the alpha values should be close to zero
Summary
The capital asset pricing model (CAPM) of Sharpe (1964), Lintner (1965) and Mossin (1966), based on pathbreaking work of Markowitz (1952) is the backbone of the current portfolio philosophy. Fama and French (1992) incorporated two additional variables or factors and concluded that stock returns are dependent on volatility and on a combination of firm size and firm value. The model prophesies that high B/M value and small size stocks are given a premium, and are an active two determinants of the expected return of the security besides the third one excess market return in proportion to its beta. The three-factor model (Fama and French, 1992, 1993, 1996) is expected to perform better than CAPM in pricing risky assets through its exposure to two additional factors.
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