Abstract
The Fama-French three-factor model (Fama & French, 1993) has been subject to extensive testing on samples of US and European nonfinancial firms over several time windows. The most accepted evidence is that size premium (SMB) and value premium (HML) other than the market risk premium help explain cross-section and time-series changes in stock returns. However, scholars have always paid little attention to the financial industry because of the intrinsic differences between financial and nonfinancial firms. The few studies that tested the model on financial firms found mixed evidence on the role of size and book-to-market ratio (B/M) in explaining stock returns. This paper tries to bridge the gap by testing the model on a sample of European financial firms. We find that size and B/M factors seem to be sources of undiversifiable risks and should therefore be included as risk premiums for estimating expected returns of financial firms. Small and high-B/M firms show higher returns that are not explained by market risk and the inclusion of SMB and HML helps improve the regression models’ goodness-of-fit.
Highlights
Pricing models are charged with the task to identify factors explaining the return of risky assets
The first formalized theory of market equilibrium can be identified in the Capital Asset Pricing Model (CAPM) independently developed by Treynor (1962), Sharpe (1964), Lintner (1965), and Mossin (1966)
We test the Fama-French three-factor model employed in the estimation of returns of financial stocks in Europe
Summary
Pricing models are charged with the task to identify factors explaining the return of risky assets. Market beta may not be sufficient to explain cross-sectional changes in stock returns as investors need to be rewarded for additional, non-diversifiable risk factors. This means that market portfolio is inefficient and market ijbm.ccsenet.org. Fama-French three-factor model (TFM) (Fama and French, 1993) is probably the most studied and popular multifactor model It shows that risk premiums built on market capitalization (MV) and book-to-market ratio (B/M) are significantly correlated with stock excess returns of non-financial firms and, combined with the market risk premium, significantly improve the model explanatory power. The paper is organized as follows: section two summarizes the main empirical evidence; section three describes sample and methodology; section four illustrates and discusses results; section five concludes
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