Stocks of Emerging and Developed Countries through the Lens of the Fama-French Three-Factor Model

Abstract

This experimental research investigates risk on emerging and developed markets. I employ the methodology of Fama-French (1993) to construct their Three-Factor model. My central hypothesis is that there is risk which cannot be captured by the Fama-French Three-Factor model and this risk is higher on emerging markets. The results suggest there is a significant part of the cross-section which remains unexplained by the three-factor model, and the unexplained part is notably higher for emerging equity markets. I assume where the explanatory power of the Fama-French three-factor model is weaker, unknown risk factors have stronger effect, and the quantity of additional risk is the unexplained part. This paper does not name and categorize the additional risk factors, the purpose of this research is mainly quantification. The main result of this paper is that it finds evidence to the existence of higher additional risk on emerging markets. The paper proves the efficiency of Size and Book-to-Market-Equity factors in the explanation of expected stock return behavior for both emerging and developed markets, but more importantly, also raises a need to include other variables. The research expands the empirical evidence of market integration and finds similar patterns of risk behavior among national economies.