Examination and Modification of Multi-Factor Model in Explaining Stock Excess Return with Hybrid Approach in Empirical Study of Chinese Stock Market

Jian Huang,Huazhang Liu

doi:10.3390/jrfm12020091

Abstract

To search significant variables which can illustrate the abnormal return of stock price, this research is generally based on the Fama-French five-factor model to develop a multi-factor model. We evaluated the existing factors in the empirical study of Chinese stock market and examined for new factors to extend the model by OLS and ridge regression model. With data from 2007 to 2018, the regression analysis was conducted on 1097 stocks separately in the market with computer simulation based on Python. Moreover, we conducted research on factor cyclical pattern via chi-square test and developed a corresponding trading strategy with trend analysis. For the results, we found that except market risk premium, each industry corresponds differently to the rest of six risk factors. The factor cyclical pattern can be used to predict the direction of seven risk factors and a simple moving average approach based on the relationships between risk factors and each industry was conducted in back-test which suggested that SMB (size premium), CMA (investment growth premium), CRMHL (momentum premium), and AMLH (asset turnover premium) can gain positive return.

Highlights

Financial markets are rife with uncertainties which make it difficult to forecast future market trends
wrong decisions (We) evaluated the existing factors in the empirical study of Chinese stock market and examined for new factors to extend the model by OLS and ridge regression model
The factor cyclical pattern can be used to predict the direction of seven risk factors and a simple moving average approach based on the relationships between risk factors and each industry was conducted in back-test which suggested that SMB, CMA, CRMHL, and AMLH can gain positive return

Summary

Introduction

Financial markets are rife with uncertainties which make it difficult to forecast future market trends. If the relationship between the risk and return can be expressed by multiple factors in a mathematical model, the standards of stock selection and corresponding investment strategies can be established. Each investor has their own risk preference, for instance, risk averse investors tend to bear lower risk and receive lower return. This specific type of investors has their preference in stock selection. In order to find suitable selection criteria, we need to quantify the relationship of risk premium factor and excess return. Investors can refer to the selection criteria to establish a corresponding trading strategy which can achieve their target excess return

Results

Discussion

Conclusion