Asset Pricing Model Study

Topics: Stock market, Investment, Capital asset pricing model Pages: 44 (16249 words) Published: April 8, 2013
Table of Contents
Introduction5
1.1 Research Background .6
1.2 Research Aim6
1.3 Research Objective 7
1.4 Research Questions 8

Literature Review 9
2.1Prior Evidence of the Four-Factor Model in the UK13
2.2Hypotheses15
Data and Methodology 17
3.1Research Data 17
3.2Research Methodology 18
Empirical Results and Discussion 21
4.1 Summary Statistics21
4.2 Data Analysis27
4.2.1 Full Sample Regression 27
4.2.1.1 Full Sample Analysis 28
4.2.1.2 Graph of the Full Sample Analysis 30
4.2.2 Bull Market Regression34
4.2.2.1 Bull Market Analysis 35
4.2.3 Bear Market Regression 38
4.2.3.1 Bear Market Analysis 39
4.2.4 Behavior Finance Arguments 40

Summary and Conclusion 42
5.1Recommendations43
References 44
Appendices 49

Table 1 : Summary Statistics 21
Table 2(a): Excess Returns on the six portfolios (Full Sample) 24
Table 2(b): Excess Returns on the six portfolios (Bear Market) 25
Table 2(c): Excess Returns on the six portfolios (Bull Market) 26
Table 3 : Regression on the six portfolios (Full Sample) 27
Table 4 : Regression on the six portfolios (Bull Market) 34
Table 5 : Regression on the six portfolios (Bear Market) 38

Figure 1 : Market Factor 30
Figure 2 : Size Factor 31
Figure 3 : Book-to-market Factor 32
Figure 4 : Momentum Factor 33

Picture 1 : Market Return 49
Picture 2 : SMB Return 49
Picture 3 : HML Return 50
Picture 4 : WML Return 50

Acknowledgement

Abstract
This paper, we study the significance of the four-factor asset pricing model (market factor, size factor, book-to-market factor and momentum factor) in explaining the cross-sectional variation in average stock returns in the United Kingdom. Our findings show that the four-factor model does work well and significant to explain the cross-sectional variation in average stock returns for July 2000 to June 2007 period. Our empirical findings indicate that on average annual premium for the market factor, size factor, book-to-market factor and momentum factor is minus 3.64 percent, 5.20 percent, 3.12 percent and 26.52 percent. Our results suggest that the small firms produce higher returns than big firms. For the high book-to-market equity stocks more likely to perform higher returns than low book-to-market equity stocks. SMB and HML are proxy for sensitivity to risk factors that capture cross-sectional variation in average stock returns. We also find that there is statistically significant in momentum factor. Moreover, we observe that the four-factor model in the UK stock market works well in explaining the variation in the stock returns no matter the market is going up or down.

1.0 Introduction
In 1970’s, (Sharpe 1964), (Lintner 1965) and (Black 1972) introduce The Capital Asset Pricing Model (CAPM) which is the first asset pricing model in finance. This model has becomes popular in explaining the relationship between return and market beta on risky financial assets. According to CAPM, as the capital market in equilibrium, investors’ willingness to bear higher risk to obtain higher expected return. Investors face only one source of uncertainty which is the performance of the market as a whole. They bear only market risk (market beta) and no other risk factor. There is a linear, positively sloped relationship under risk and expected return on risky financial assets, noted by (Sharpe 1964). In other words, the expected return of a security or portfolio is greater, the greater its market risk. 1.1 Research Background

However, recent empirical tests in the area of asset pricing indicate that the cross-sectional of average stock returns does not have relation or lack of supportive evidence to the market beta of the CAPM. (Fama and French 1992) state that beta is nearly worthless as an...

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