Modified Fama-French Three-Factor Model and the Equity Premium: An Empirical Test in the Chinese Stock Market

Abstract

Fama-French model is proposed as an alternative to the CAPM model to explain the equity premium found in stock market. This paper applies the original and modified Fama-French three-factor model in three industries (Finance & Insurance, Real Estate, and Pharmaceutical) of China’s Shanghai Stock Exchange market. The study examines the relation between risk premium and the three Fama-French factors using six portfolios sorted by market capitalization and book-to-market ratio (inverse of price-to-book ratio). The result shows that Fama-French factors have consistent explanatory power of the risk premium. Using the original Three-Factor Model and CAPM Model as reference, the modified Three-Factor Model, with cross and quadratic terms added, significantly improves the performance of the model.