Comparative Study of CAPM, Fama and French Model and Reward Beta Approach in the Brazilian Market

Abstract

This article tests and compares three alternative models for the prediction of the expected returns in the Brazilian stock market: 1) the Sharpe-Litner-Mossin version of the CAPM; 2) the Fama and French Three-Factor model; 3) and the Reward Beta Model, presented by Bornholt (2007). The two-step test methodology for general balance models was used as empirical procedure: the first step consists of determining the models parameters based on time series regressions, and in the second step the estimated parameters are used as explanatory variables in cross section regressions. The tests were conducted on portfolios, in accordance with the Fama and French's (1993) and Bornholt's (2007) methodology, and applied in two sub-samples of stocks with available data in the Sao Paulo Stock Exchange (BOVESPA): the ex-ante sample comprises the period from July 1995 to June 2001 and the ex-post sample the period from July 2001 to June 2006. As well as other evidences found in the Brazilian market, the results tend to support the Fama and French Three-Factor model to explain future returns, much tough the factor that captures the book-to-market effect has not revealed itself to be significant. Thus, it is indicated for prediction of expected returns in the Brazilian stock market, a Two-Factor model: 1) one that captures the market excess of return; and 2) another one that captures the size effect of the firm.