Noisy prices and the Fama–French five-factor asset pricing model in China

This paper provides an empirical evaluation of the five-factor model recently presented by Fama and French (2015a) that augments the traditional three-factor model with two new factors related to profitability and investment, taking into account the bias in mean returns induced by noise in prices. Using an extensive sample over the period 1997 to 2015, we find that the five-factor model consistently outperforms the three-factor model in the Chinese equity market. In contrast to the findings in Fama and French (2015a), both value and profitability factors are important, while the investment factor is found to be redundant for describing average returns in our sample. With respect to the double-sorted left-hand-side (LHS) portfolios, the main problem with the five-factor model is its failure to fully capture the high average returns of stocks whose returns perform like those of growth firms that invest conservatively due to low profitability. On the other hand, although we find mixed results in the three-dimensional sorting, the LHS portfolios with extremely low average returns are those that cause serious problems for the five-factor model.     

Asset Pricing and Momentum: A South African Perspective

Both the capital asset pricing model and Fama and French’s (1993) three-factor model have consistently failed to explain momentum in stock returns, with only Carhart’s (1997) four-factor model having some success in this regard. This study examines whether an alternative three-factor model proposed by Chen, Novy-Marx, and Zhang (2011) and a five-factor model forwarded by Fama and French (2015), which both include profitability and investment as pricing factors, can explain momentum on the South African market. Consistent with international evidence, the pricing errors from these two models are lower and although these errors remain significant, the results reveal that profitability and, to a lesser extent, investment are important risk-based factors that must be considered in explaining the short-term continuation in stock returns.     

Size,value, profitability,and investment: Evidence from emerging markets

In this study, we investigate how the Fama and French three-, four-, and five-factor models perform in emerging markets. We find that the four- and five-factor models perform better than the three-factor model in most of our tests. We note that the value factor seems to be somewhat redundant in the presence of profitability and investment factors. We find clear evidence of size effects in average stock excess returns, little evidence of value and profitability effects, and some investment effects. Finally, the local factors perform better than the US and global factors do, showing evidence of emerging market segmentation.     

A Better Model? An Empirical Investigation of the Fama–French Five‐factor Model in Australia

Recently, Fama and French ( 2015a ) propose a five‐factor model by adding profitability and investment factors to their three‐factor model. This model outperforms the three‐factor model previously proposed by Fama and French ( 1993 ). Using an extensive sample over the 1982–2013 period, we investigate the performance of the five‐factor model in pricing Australian equities. We find that the five‐factor model is able to explain more asset pricing anomalies than a range of competing asset pricing models, which supports the superiority of the five‐factor model. We also find that despite the results documented by Fama and French ( 2015a ), the book‐to‐market factor retains its explanatory power in the presence of the investment and profitability factors. Our results are robust to alternative factor definitions and the formation of test assets. The study provides a strong out‐of‐sample test of the model, adding to the comparative evidence across international equity markets.     

Exchange risk and asset returns: A theoretical and empirical study of an open economy asset pricing model

This study develops a consumption-based asset pricing model in which domestic consumers can buy goods from domestic and foreign markets but can only invest in domestic markets. In this model, the exchange rate influences asset prices through the marginal utility of consumption and increases the risks investors face. We find that our model can successfully price the 25 Fama–French portfolios and industry portfolios in the Chinese market, and the exchange rate is an important pricing factor in the unconditional linear model. We also find that the exchange risk is time-varying and countercyclical, which can help to explain the countercyclicality in equity premium.     

The cross-section of emerging market stock returns

Using monthly stock returns from 28 emerging market countries and a total sample period of 21 years, we investigate the predictive power of a broad set of factors. We document that the factor definitions of the Fama and French (2015) five-factor model are less robust compared to alternative factor definitions. In contrast, the anomalous returns associated with cash flow-to-price, gross profitability, composite equity issuance, and momentum are pervasive as they show up in equal- and value-weighted portfolio sorts as well as in cross-sectional regressions. In contrast to financial theory and in line with previous findings, we do not find a positive cross-sectional relationship between risk and return. Finally, return forecasts derived from the alternative factor definitions are superior in their out-of-sample predictive ability to the ones derived from the five-factor model.     

Virtue Remains After Removing Sin: Finding Skill Amongst Socially Responsible Investment Managers

We examine the investment skill of socially responsible investment (SRI) fund managers. Prior studies use the ‘alpha’ from standard asset pricing models as a proxy for management skill. However, implicit in the use of such models is that managers operate under no investment constraints. In the SRI context, this is patently false and can lead to biased alpha estimates and false conclusions about the existence of skill. We introduce a novel three-factor Fama–French asset-pricing model with the aim of estimating alpha more accurately and hence investment skill, without bias. This model excludes SRI-prohibited industries such as defense, alcohol, tobacco and gambling in the construction of the Fama–French market, value and size risk factors. We show that the exclusion of the SRI-prohibited industries leads to subtle and complex changes to the risk factors that drive SRI returns. When we re-estimate alpha using the new model we find, in contrast to the conventional Fama–French model, evidence of statistically and economically significant alpha. Furthermore, the risk loadings on the new risk factors are similar to those of the original Fama–French model suggesting that changes in risk loadings are not responsible for the finding of significant skill.     

Common Risk Factors Versus a Mispricing Factor of Tokyo Stock Exchange Firms: Inquiries into the Fundamental Value Derived from Analyst Earnings Forecasts*

We search for common factors and/or a mispricing factor for Tokyo Stock Exchange firms. We utilize the Edwards–Bell–Ohlson model to compute the firms' fundamental value and divide this value by the firms' market price to construct a new variable called a ‘value‐to‐price ratio’ (VPR). We find that this VPR variable can generate abnormal returns even after adjusting for the risk factors related to portfolio style differences. To find out whether it is indeed a risk factor or simply a characteristic, we construct return difference portfolios of the high VPR stocks minus the low value‐to‐price stocks and call this portfolio the upward‐forecast minus downward‐forecast (UMD) factor. Fama and MacBeth test indicate that the risk premium for this UMD factor is positive. The best model in terms of the adjusted R² value is the four‐factor model in which the UMD factor is added to the Fama and French three factors. GMM Euler condition tests reveal that the UMD factor helps to price assets and that the four‐factor model is not rejected. We conclude the VPR variable contains new information content that is not contained in the conventional Fama and French's three factors.     

Media Corruption: A Chinese Characteristic

The core goal of this study is to empirically investigate whether there is a “world price” of corporate sustainability. This is assessed in the context of standard asset pricing models—in particular, by asking whether a risk premium attaches to a sustainability factor after controlling for the Fama–French factors. Both time-series and cross-sectional tests are formulated and applied. The results show that (1) global Fama–French factors have strong power to explain global equity returns and (2) sustainability investments have no significant impact on global equity returns. The absence of a significant relationship between sustainability and returns implies that large institutional investors are free to implement sustainability mandates without fear of breaching their fiduciary duties from realising negative returns due to incorporating a sustainability investment process.     

Does the Fama and French Five‐Factor Model Work Well in Japan?

In this study, we investigate whether the five‐factor model by Fama and French (2015) explains well the pricing structure of stocks with long‐run data for Japan. We conduct standard cross‐section asset pricing tests and examine the additional explanatory power of the new Fama and French factors; robust‐minus‐weak profitability factor and conservative‐minus‐aggressive investment factor. We find that robust‐minus‐weak and the conservative‐minus‐aggressive factors are not statistically significant when we conduct generalized method of moments (GMM) tests with the Hansen–Jagannathan distance measure. Thus, we conclude that the original version of the Fama and French five‐factor model is not the best benchmark pricing model for Japanese data during our sampling period from the year 1978 to the year 2014.     

Show me the money: Option moneyness concentration and future stock returns

Informed traders often use options that are not in-the-money due to higher potential gains for a smaller upfront cost. Thus, trading activity by option moneyness should be a gauge of informed option trading. We construct a dollar volume-weighted average moneyness measure to capture option trading activity at different moneyness levels. Stock returns increase with this measure, suggesting more trading activity in options with higher leverage predicts future stock returns. Our results hold cross-sectionally and at the portfolio level yielding a Fama–French five-factor α of 12% per year for all stocks and 33% per year for high implied volatility stocks.     

The formulation of the four factor model when a considerable proportion of firms is dual-listed

We examine the performance of the Fama–French–Carhart four factor asset pricing model in an economy, Israel, where a relatively large proportion of shares (14.4% in our sample) are dually listed, i.e., trade also on NYSE or NASDAQ. We find that a hybrid model (adding U.S. or global factors to the local 4 factor model) performs only slightly better than the local model, casting doubt on the practical necessity of hybrid models in emerging markets. Further tests suggest that the dually listed shares should not be excluded when constructing the local factors.     

Option implied cost of equity and its properties

The estimation of the cost of equity capital (COE) is one of the most important tasks in financial management. Existing approaches compute the COE using historical data, i.e. they are backward‐looking methods. This study derives a method to calculate forward‐looking estimates of the COE using the current market prices of stocks and stock options. Our estimates of the COE reflect the expectation of the market investors about the COE during the life of the investment project. We test empirically our method and compare it with the Fama/French (1993) three‐factor model for the S&P 100 firms. The empirical results indicate that our COE estimates (1) are plausible and stable over the years as required by appropriate discount rates for capital budgeting, (2) yield an equity risk premium close to the market equity risk premium reported by Fama E. F. and French K. R. (2002), (3) generate strong return‐risk relationships, and (4) are significantly related with investor sentiment. © 2009 Wiley Periodicals, Inc. Jrl Fut Mark 29: 599–629, 2009     

The cross-section of returns in frontier equity markets: Integrated or segmented pricing?

Is asset pricing segmented or integrated in frontier equity markets? To answer this question, we examine the returns on more than 4500 stocks from 22 frontier countries for the years 1997–2018. We evaluate the performance of a few major asset pricing models. We document strong value and momentum effects but find no consistent evidence regarding size, investment, and profitability premia. The recent six-factor model of Fama and French (2018) outperforms other models and best explains the cross-sectional and time-series variation in returns. Our results point to low integration of frontier equities, even after the global financial crisis. Local risk factors explain the behavior of prices much better than their global counterparts do. The low correlation of these risk factors allows augmenting the efficient frontier of an international investor.     

Does High Service Quality Reduce Risk or Create Idiosyncratic Returns?

This article explores the impact of service quality on idiosyncratic returns, idiosyncratic risk (nonsystematic risk), and beta (systematic risk). Service quality was derived from the airline quality rating, and three dependent variables were calculated by the Fama–French four-factor model. The data includes 1,512 monthly records from 1997 to 2006, across 21 airlines. Multiple regression and vector autoregressive models were applied to test relationships among all, low-cost, and non-low-cost airlines. The study found that service quality has a positive impact on idiosyncratic returns in non-low-cost airlines; non-low-cost airlines are less affected by changes in the external environment.     

Unveiling Contemporaneous Relations Between Jump Risk and Cross Section of Stock Returns

This study analyzes the impact of time varying jump risk on aggregate returns. We, in particular, examine the pricing of jump size and intensity components in the cross section of stock returns for four Asian markets. We use stochastic volatility model with jumps to estimate jump size and intensity. Fama–MacBeth regression results indicate that both jump size and intensity have statistically significant effect on expected returns. A one standard deviation increase in jump intensity beta lowers the expected annual returns by 1% for Japan, 2% for China, 5% for India, and 7% for South Korea. The results are consistent even after controlling for the Fama and French three factors, firm size, and liquidity proxies.     

Estimating the Cost‐of‐Equity Capital Using Empirical Asset Pricing Models

Empirical asset pricing models seek to capture characteristic‐based patterns in the cross‐section of average stock returns. I propose a new approach for constructing these models, and investigate its performance with respect to estimating the cost‐of‐equity capital. Using a model that accounts for the cross‐sectional relation between five characteristics and average stock returns, I obtain cost‐of‐equity estimates that outperform those produced by the Fama‐French five‐factor model in out‐of‐sample tests. Because the proposed approach builds directly on standard cross‐sectional regression techniques, it provides complete flexibility in choosing the firm characteristics used to formulate the cost‐of‐equity estimates.     

A robust model of the convenience yield in the natural gas market

This study advances the research on the convenience yield of natural gas. Econometric models confirm that air temperature is an important explanatory variable in addition to storage levels. Furthermore, an extended linear model shows that one has to account for a changing cost of physical storage in the spirit of Brennan ( 1958 ). Besides this, an alternative regime‐switching model for the convenience yield helps to put in perspective a prominent finding by Fama, and French ( 1987 ). That is, given binding capacity constraints for gas storage, the variance of the futures' basis will increase rather than decrease with the storage levels. Finally and most importantly, robustness tests demonstrate that the extended linear model produces the most viable forecasts and that these forecasts can help to amend the performance of reduced‐form models for the gas spot price. © 2010 Wiley Periodicals, Inc. Jrl Fut Mark     

Ability parity model for optimal fund allocation: Evidence from China's mutual fund markets

We propose in this article a novel ability parity model for optimal fund allocation. Compared with the traditional portfolio selection methods which directly work on asset returns and/or risk (volatility), the proposed ability parity method focuses mainly on the allocation between the stock selection ability and market timing ability of fund managers, which essentially determines fund performance (Fama, 1972). Using the data of China's mutual fund markets, we find strong and robust evidence that the proposed ability parity model delivers significantly higher return, skewness, and Sharpe ratio than traditional models and the benchmark index, while having volatilities comparable with traditional models.