A ComparativeJournal

Asian-African AnalysisofofEconomics
the Three-Factor
and Econometrics,
and the Capital
Vol. Asset
14, No.
Pricing
2, 2014:
Models...
237-257 237

A COMPARATIVE ANALYSIS OF THE THREE-FACTOR

AND THE CAPITAL ASSET PRICING MODELS IN
THE NIGERIAN STOCK MARKET
AJAO, M. Gabriel* and IGBINOSA, Sunday*

ABSTRACT
The study seeks to determine the risk factors in asset pricing in the Nigerian Stock Market
through a comparative analysis of the three factor model and the Capital Asset Pricing Model.
Specifically, it examines the behaviour of stock returns in relation to market beta, firm size
(market equity), and book-to-market equity (BE/ME) factors. A sample size of sixty eight stocks
was selected from all stocks quoted on the Nigerian Stock Exchange (NSE) from 2003 to 2012.
The study tests the Fama and French (1992) three factor model in explaining the variation of
stock returns relative to the Capital Asset Pricing Model (CAPM) on Nigerian Stock Market
data. The Ordinary Least Square (OLS) multiple regression analysis was employed to regress
monthly excess portfolio returns on excess market returns, firm size and book-to-market-equity
ratio. The results obtained from the analysis reveal significant relationships between expected
portfolio returns and excess stock market returns, firm size and book-to-market equity factors
respectively. This indicates that the Fama and French three factor model explains the variation
of stock returns better than the single factor CAPM in the Nigerian stock market. The study
recommends that fund managers, investors and researchers should be cautious in their use of
CAPM as an asset pricing model due to its limitation as a single factor model which does not
capture in totality the risk factors affecting asset pricing and returns in the stock market.
Keywords: Risk factors, Asset pricing, stock returns, CAPM, Three factor model
JEL classification: C22, C53, G12

1. INTRODUCTION
Much of the discourse in modern finance concerns the relationship between expected return
and risk. In the context of rational investors and equity markets, the expected return is mainly
related to the underlying risk. Consequently, substantial effort has been made to identify factors
that capture such risk as well as determine assets prices in the equity markets. In the same vein,
the way investors act upon a set of estimates in determining the best investment decisions under
different probabilities can determine how aggregate investors behave and how prices are
determined in the stock market. By constructing general equilibrium models, the relevant measure
of risk can be uncovered and the relationship between expected return and risk for any asset can
be determined. The main issues in asset pricing theory are the measurement of expected return
and the calculation of risk that is associated with the return.
*
Department of Banking and Finance, Faculty of Management Sciences, University of Benin, Benin City,
Edo State, Nigeria, E-mails: mayourwah@yahoo.com; ajao.mayowa@uniben.edu; sigbinosa@gmail.com
238 Ajao, M. Gabriel and Igbinosa, Sunday

Factors capturing assets risk in the market place have been identified on the basis of existing
theories and empirical investigations. The market beta from the Capital Asset Pricing Model
(CAPM) of Sharpe, (1964); Lintner (1965); Mossin, (1966) and Black, (1972) is the fundamental
of the identified factors while the CAPM is the first model in asset pricing theory (after the
mean-variance analysis) of Markowitz (1952). The CAPM is the most widely used model
because of its simplicity and underlying assumption that investors respect the mean-variance
criterion in choosing their portfolios. Besides CAPM, other factor pricing models that have
attempted to explain the cross-section of average assets returns include: the Inter-temporal
Capital Asset Pricing Model, ICAPM (Merton, 1973), the Arbitrage Pricing Model (APM)
(Ross, 1976), and the consumption-based Capital Asset Pricing Model (CCAPM) (Rubinstein,
1976; Lucas, 1978; Breeden 1979; Mehra and Prescott, 1985). Miller (1999) states that CAPM
not only expressed new and powerful insights into the nature of risk but also through its empirical
investigation contributed to the development of finance.
The well-known conclusion of the CAPM is that the expected excess return on an asset
equals the beta of the asset times the expected excess return on the market portfolio, where the
beta is covariance of the assets return with the return on the market portfolio divided by the
variance of the market return. However, the validity of the CAPM conclusion has been the
subject of several criticisms, for example, Roll (1977) argues that CAPM cannot be tested
because the tests involve a joint hypothesis on the model and the choice of the market portfolio.
On the other hand, many patterns emerge from empirical studies which are not explained by
the CAPM; such as the case of expected returns and earnings to price ratio that exhibiting a
positive relation (Basu, 1977, 1983), small capitalizations having higher expected returns than
big capitalizations (Banz, 1981), and the positive relationship between the level of debt and
stock returns (Bhandari, 1988). There is, therefore, the need to look for other factors that play
significant role in explaining the behaviour of expected stock returns. Fama and French (1992)
find that besides beta, two additional factors firm size and book-to-market ratio play an
important role in explaining the cross section of expected stock returns. They conclude that the
combination of size and book-to-market equity performs best in cross sectional stock risk-
return analysis and when these two factors are accounted for, CAPM beta becomes insignificant.
Since its introduction in 1992, the Fama-French three factor model has been subject of
much academic debate and empirical application especially in the developed markets (Hodrick
and Zhang, 2001). While the model performs exceptionally well compared to the single
factor Capital Asset Pricing Model (CAPM), its performance against other multifactor models
in general is inconclusive (Ruzita, 2006). However, the most well known model in the current
finance literature is the Fama-French three factor model. Liew and Vassalov (2000) investigate
the extent to which profitability of the size effect and book-to-equity factor effect can be
linked to future economic growth and conclude that indeed, the Fama-French (1993, 1995,
1996) hypothesis is supported across various markets. It is therefore, important to analyse
these relationships in different settings to improve our understanding of the degree to which
they are generally applicable. To the best of my knowledge, it is pertinent to note that most
of the applications of the Fama-French three factor model for asset pricing has been limited
to the United States (US), Europe and Asian stock markets, while this model has only been
A Comparative Analysis of the Three-Factor and the Capital Asset Pricing Models... 239

applied to the South-African Market (Piesse and Hearne, 2005) and Mauritius market
(Bundoo, 2011) in Africa. While in Nigeria most studies on asset pricing focused mainly on
the application of Capital Asset Pricing Model, more recently, Tafamel (2012) in his
comparative study of CAPM and APT predictive properties finds that the APT outperforms
CAPM in predicting equity returns in the Nigerian Stock Market. In the same vein, Osamwonyi
and Aseins (2012) validates the application of CAPM in analyzing equity risk and return in
the Nigerian Stock Market.
The main purpose of this paper is to investigate the explanatory power of market beta,
firm size, and book-to-market ratio (the comparison of the CAPM versus three factor model)
on the cross-section of expected stock returns by using sample of firms listed on NSE (Nigerian
Stock Exchange, 2003-2012). This study also attempts to determine the applicability of the
three factor model in the Nigerian stock market in a bid to bridge the gap between theoretical
and empirical studies in Nigeria.

2. THEORETICAL AND EMPIRICAL LITERATURES

Stock markets are important institutions in long term financial intermediation. For several reasons,
developed stock markets are important for promoting the efficiency of investments, generating
lower cost of capital for firms, as well as giving investors the opportunity to price and hedge
against risk. These benefits of developed stock markets may be lacking in emerging stock
markets as empirical assessment of the stock markets role in enhancing efficient investments
is linked to measures of risk-return relationship and asset price development (Demirguc-kunt
and Levine, 1993). For most investors and stakeholders in the financial system, explaining
asset returns has been subject of intense debate as there are no asset pricing models with clear
testable predictions about risk and return. The Capital Asset Pricing Model (CAPM) of Sharpe
(1964), Lintner (1965), Mossin (1966), and Black (1972), however, marks the birth of asset
pricing theory (Osamwonyi and Asein, 2012). While the CAPM is an extremely elegant and
useful tool, there are concerns about the overall efficacy of the model as several criticisms have
come to the fore of academic research because the model is plagued with several limitations,
especially in the area of unrealistic assumptions, the use of single market beta for empirical
testing and inability to explain the behaviour of expected stock returns effectively (Strattman,
1980; Reinganum,1981; Lakonishok and Shapiro,1984; Chan, Hamao and Lakonishok 1991).
Based on the identified weaknesses of CAPM, Fama and French (1992) show that stock
risks are multidimensional; therefore many factors besides market beta play significant role in
explaining the risk-return relationship. Several studies [Banz (1981), Basu (1983), Keim (1983),
Cook and Rozeff (1984), Reinganum (1982), Lakonishok and Shapiro (1984), Rosenberg,
Reid, and Lanstein (1985), De Bondt and Thaler (1987)] have documented that average return
is related to firm size, book-to-market equity ratio (BE/ME), earnings to price ratio (E/P),
cashflow to price ratio (C/P) and past sales growth. However, Fama and French (1992) conclude
that the combination of size and book-to-market equity performs best in explaining the cross
sectional variation in stock returns and when these two factors are accounted for, CAPM beta
becomes insignificant. In this respect, Fama and French (1992, 1993, 1995, and 1996) propose
a three factor model. The model states that the expected return on a portfolio in excess of the
240 Ajao, M. Gabriel and Igbinosa, Sunday

risk-free rate is explained by the market risks factor; the size effect factor and the book-to-
equity effect factor.
The Fama and French (1992) three factor model has been the subject of much academic
contention and has also been subject to intense econometric investigation in different stock
markets at different times. While some researchers supported the conclusion of Fama and
French (1992) others such as Daniel and Titman (1997) do not for several reasons.
Charitou and Constantinidis (2004) empirically examined the Fama and French (1993)
three factor model using Japanese data over the period of 1992 to 2001. The findings reveal
significant relationship between the three factors and the expected stock returns in the Japanese
market. Drew and Veerarachavan (2003) test the Fama and French three factor model in the
Asian region (Hong Kong, South Korea, Malaysia and the Philippines) and find that size and
value effects can be identified in these four markets using a cross section approach and that the
Fama-French model explains the variation in returns better than the single index model. Shum
and Tang (2005) test common risk factors in assessing returns in Asian stock markets, using
sample of assets listed on the Hong Kong, Singapore, and Taiwan stock exchanges. Their
results confirm those of Fama and French for the US when using contemporaneous market
factors, but the augmented model that includes size and book to market ratios report no
significant improvement over the traditional CAPM.
Daniel and Titman (1997) use data from NYSE and form 25 stock portfolios on the basis
of size and book to market equity for July 1963 to December 1993, similar to those used by
Fama and French (1993) and rejected the findings of the Fama-French three factor model.
They find that size and book to market ratios are both highly correlated with the average
returns of common stocks. Daniel, Titman and Wei (2001) continue the Daniel and Titmans
(1997) study by examining monthly data on common stocks listed on the Tokyo Stock Exchange
(TSE) from January 1971 to December 1997. They rejected the Fama-French three factor
model in favour of the characteristic model. However, Davis, Fama and French (2000) using
an extended data set from 1929 to 1997 contend that Daniel and Titmans (1997) results are
specific only to the relatively short data set that they used and consequently came out in favour
of the risk explanation.
Furthermore, Lam (2002) using data for 100 firms listed in the Stock Exchange of Hong
Kong (SEHK) from July 1980 to June 1997 reports results that support the three factor model.
He asserts that beta is unable to explain the average monthly returns on stocks, but size, book-
to-market equity ratios seem able to capture the cross-sectional variation of returns. Halliwell,
Heaney and Sawicki (1999) in their study of the Australian Stock Exchange for the period of
January 1981 to June 1991 report a statistically significant size effect but find little evidence of
a statistically significant book-to-market effect and conclude that the role of this factor may
not be as strong as suggested in the literature. Similarly, Faff (2001) uses 24 Australian industry
portfolio data covering a period from January 1991 to April 1999, and finds strong support for
the Fama-French three factor model but with a negative significant size effect. Gaunt (2004)
extends the Halliwell et al (1999) data set and covers a period from 1993 to 2001, reports a
statistically significant size effect and strong evidence of a book-to-market effect and a
A Comparative Analysis of the Three-Factor and the Capital Asset Pricing Models... 241

significant improvement in the explanatory power of the three factor model over the conventional
CAPM.
Also, Bundoo (2011) in a study of the Stock Exchange of Mauritius for the period January
1997 to June 2003 based on a sample of 40 listed companies, reports that the Fama-French
three factor holds for the Mauritius market and that both the size and book-to-market equity
effect are present in the market. Besides, the augmented Fama and French model shows that
the time-variation in betas is priced, but the size and book-to-market equity effects are still
statistically significant. Kothari, Shanken and Sloan (1995) re-examine the results presented
by Fama and French (1993) by seeking to determine whether beta explains the cross sectional
variation in average returns and also whether BE/ME capture the cross sectional variation in
average returns in the US market from 1947 to 1987. They find that BE/ME is weakly related
to average stock returns.
Dimson, Nagel and Quigley (2003) test for a value premium effect in the UK market with
a new defined data set of accounting information covering the period 1955-2001 to cover the
whole population of stocks ever listed on the London Stock Exchange. They find a strong
value premium effect for stocks within the small cap and large cap universe. Malin and
Veeraraghavan (2004) investigated the three factor model on three major European markets
namely: England, France and Germany over the period 1992 to 2001. They find evidence of a
small firm effect in France and Germany and a big firm effect in the UK. Their final results,
however, contradict value effect as no evidence of a value effect was identified in any of the
markets. Their findings also support the conclusions of Al-Horani, Pope and Stark (2003) that
the CAPM beta does not appear to have significant explanatory power for the cross-section of
UK stock returns.
Maroney and Protopapadakis (2002) tested the Fama and French three factor model on
stock markets of Australia, Canada, Germany, France, Japan, the UK and the US. The size
effect and the value premium survive for all the countries examined. They conclude that the
size and the BE/ME effects are international in character, and that using a Stochastic Discount
Factor (SDF) model and a variety of macroeconomic and financial variables, do not
diminish the explanatory power of BE/ME and size. The positive relations of returns with
BE/ME and the negative relationship with size remains in the model. Griffin (2002), Griffin
and Lemon (2002) on the other hand, using monthly data for 1521 companies in Japan, 1234
in the UK, and 631 in Canada from January 1981 to December 1995, suggest that practical
applications of the Fama-French three factor model are best performed on a country specific
basis.
Based on the empirical review highlighted above, it is obvious that most of the application
of Fama and French three factor model has been predominantly carried out in the developed
markets. This study therefore aims to contribute to the extant literature through a comparative
analysis of the CAPM and the Fama-French three factor model. Specifically, we investigate
the explanatory power of market factor, size effect and book-to-market equity effect on the
cross section of expected stock returns of quoted stocks on the Nigerian Stock Exchange (NSE)
for the period of January 2003 to December 2012.
242 Ajao, M. Gabriel and Igbinosa, Sunday

3. DATA AND METHODOLOGY

The focus of this study is identifying the risk factors in asset pricing in the Nigerian Stock
Market through a comparative analysis of the three factor model and the CAPM. The study
utilizes monthly data covering 2003-2012 sample periods. We consider this period to be long
enough to assure the adequacy of data and reliability of results. The year 2003 was taken as the
starting year because monthly treasury bill (proxy for risk free rate) data are not available in
Nigeria prior to 2003 while 2012 was taken as terminal year, also for reason of data availability.
A total of Sixty-Eight (68) stocks were selected out of all the stocks listed on the NSE by means
of judgmental sampling technique as the selected stocks must conform to some criteria such as
frequency of trading, presence in the market, and capitalization.

3.1. Model Specification

3.1.1. The Fama and French Three Factor Model
The Fama and French (1992, 1993) three factor model uses the standard multiple regression
approach. It is expressed in the form of equation (I) below:
Rp,t - Rf,t = apt + bp (Rm,t Rft) + Sp (SMB) + hp (HML) + mpt (I)
where
Rp,t = Average monthly return of portfolio p
Rft = Monthly risk free rate
Rm,t = Expected monthly market return
SMB = Small minus big (proxy for company size)
HML = High minus low (proxy for value premium i.e. BE/ME)
bp, sp and hp = Factor sensitivities or loading which are the slope coefficients in the
time series regression
pt = The intercept of the time series regression
pt = The stochastic error term

3.1.2. The Capital Asset Pricing Model (CAPM)

In order to test the CAPM of portfolio in this study, we construct six portfolios and estimate the
regression model for each of them by imposing hp=sp=0 in equation (I). Therefore, our portfolio
CAPM equation for this study is as follows:
Rp,t - Rf,t = pt + bp (Rm,t Rft) + pt (II)
Where: All the variables are fully defined in equation (I)
Equation (II) enables us to effectively compare the performance of CAPM and the three
factor model and to identify the risk factors in asset pricing in the Nigerian stock market.
3.1.3. Portfolio Formation
In constructing our portfolios for this study, we classify our sample of stocks listed on Nigerian
Stock Exchange by SIZE and BE/ME based on Fama and French (1992; 1993) specification.
A Comparative Analysis of the Three-Factor and the Capital Asset Pricing Models... 243

(a) The Size Classification: This grouped the stocks in two classes: small capitalization
and big capitalization. We define our size as Market Equity which is market price
multiplied by number of outstanding shares for each of the sample firm. We use the
size (ME) capitalization as the market equity as at the last trading day of December of
each year in the formation of portfolios for the period January to December of subsequent
fiscal year. Having done this, all the sampled stocks were ranked according to the size
capitalization computed and we then determine the median of NSE stocks in order to
split the market into two halves. Firms with market equity less than the median value
were considered as SMALL Equity firms while those with values greater than the
median value were considered as BIG market equity firm.
(b) The Book-to-Market Equity (BE/ME) classification:
BE
We calculate the BE/ME for each of the firm as = (III)
ME
Where BE is the Book Equity defined as the book value of common shareholders funds
for each firm {this includes balance sheet deferred taxes (if available), minus the book
value of preferred stock (if available) and outside equity interest}
ME is the Market Equity defined as the market share price at time t multiplied by the
number of outstanding shares (issued and fully paid) for each firm.
The companies were all ranked by BE/ME ratio and then divided into three groups according
to the calculated BE/ME ratio following the Fama and French (1993) methodology: First group,
30% of all stocks that have highest BE/ME (called High BE/ME); second group, 40% of all
stocks that have BE/ME in medium (called medium BE/ME); and the last group, 30% of all
stocks with lowest BE/ME (called low group). All stocks with negative BE/ME were excluded
from the grouping in order to prevent distortion of the results. According to Fama and French
(1993), the split of the stocks into different categories (two ME groups and three BE/ME
groups) was arbitrary and there was no reason that tests should be sensitive to this choice.
Following this argument and on the basis of the above classification by Size (ME) and Book-
to-market equity (BE/ME), we construct six (6) intersecting portfolios, namely: SL, SM, SH,
BL, BM and BH. Where SL: consists of all stocks in the small market equity group that are
also in the low BE/ME group; SM: consists of all stocks in the small market equity group that
are also in the medium BE/ME group; SH: consists of all stocks in the small market equity
group that are also in the high BE/ME group; BL: consists of all stocks in the Big market
equity group that are also in the low BE/ME group; BM: consists of all stocks in the Big
market equity group that are also in the medium BE/ME group; and BH: consists of all stocks
in the big market equity group that are also in the high BE/ME group.
3.1.4. Portfolio Returns
The monthly return of each portfolio is the value-weighted monthly returns of the stocks
included in the portfolio, estimated by equation (IV) below:
n
R pm Wi, m Ri, m (IV)
i 1
244 Ajao, M. Gabriel and Igbinosa, Sunday

Where, Rpm is the portfolio P return in month m

Ri,m is the stock i return in month m
Wi,m is the weight of stock i in the portfolio P (this is estimated as the ratio of market
value of stock i on the total market value of portfolio P in month m)
n is the number of stocks in portfolio P
SMB (Small minus Big): This represents the risk factor of rate of return involved with size
effect. SMB = (Average returns of small size) minus (Average returns of Big size)
SMB = 1/3(S/H + S/M + S/L) 1/3(B/H + B/M + B/L) (V)
HML (High minus Low): This represents the risk factor of return rate involved with ratio
of book to market value effect.
HML = (S/H + B/H) - (S/L + B/L) (VI)

3.1.5. The Stationarity test of Data

The stationarity property of each of the time series variable is investigated through the
Augmented-Dickey Fuller (ADF) test for the unit root following Dickey and Fuller (1981). The
ADF test consists of estimating the following regression:

Yt 1 2t Yt 1 im1 Yt 1 t (VII)
Where Yt represents time series to be tested 1 is the intercept term, 2 is the coefficient of
interest in the unit root test, is the coefficient of the augmented lagged first difference of Yt-1 to
represent the Pth order autoregressive process, and t is the pure white noise error term.

4. DATA ANALYSIS AND RESULTS

4.1. Stationarity Test of the Variables

Table I
Stationarity Test of the Variables

Variables Unit Root Test Conclusion Remark

Level First Diff
BH -6.184969* -9.036207* I(1) Stationary
BM -10.27638* -15.0875* I(1) Stationary
BL -8.140077* -8.805397* I(1) Stationary
SL -8.71544* -9.641976* I(1) Stationary
SM -9.303993* -13.03099* I(1) Stationary
SH -8.160194* -17.38463* I(1) Stationary
Rm -9.151454* -8.70767* I(1) Stationary
Rf -2.285273 -8.015244* I(1) Stationary
HML -10.54145* -10.04298* I(1) Stationary
SMB -9.564405* -9.832056* I(1) Stationary
NB: * represents 1% level of significance.
Source: Authors Computation, (2014) with E-view 7.0
A Comparative Analysis of the Three-Factor and the Capital Asset Pricing Models... 245

Table I shows the stationarity test of the variables using the Augmented Dickey Fuller
(ADF) test. All the variables are found to be stationary at levels except Rf. Based on the non
stationarity of Rf, all the variables were differenced once to further check their stationarity
status. At first differencing, the calculated ADF test statistics clearly reject the null hypothesis
of unit root when compared with their corresponding critical values, hence the ADF test confirm
the stationarity of each variable at first difference and depict the same order of integration I (1)
even at the 1% level for all the variables. Therefore, we conclude that the time series variables
are stationary.

4.2. Fama and French Three Factor Model and Capital Asset Pricing Model
Table II shows the results for the Fama and French three-factor model and the Capital Asset
Pricing Model (CAPM) for the sampled stocks of the Nigerian Stock Exchange from January
2003 to December 2012.
For the three factor model, the ap coefficients (intercepts) of all the six portfolios are
different from zero except for the BM portfolio with a coefficient of -0.0876. While the intercepts
of portfolios BH and SM are statistically significant at 5%, that of SL is significant at 10%
level. However, the intercepts of BM, BL and SH are not significant at any level. This indicates
the presence of abnormal returns on the NSE during the period under consideration, however
the model captures the common variation in stock returns. The market factor coefficients (p)
are positive and close to 1 for all the six portfolios and are all statistically significant (different
from zero) even at 1% level. This implies that all the stocks in the six portfolios irrespective of
size generally move in step with the market. This finding is consistent with Gaunt (2004) who
shows that beta risk tends to be greater for smaller companies and those with lower BE/ME
ratios.
For the size factor coefficient (Sp), they take positive values in three out of the six portfolios.
All small size portfolios have highly significant (at 1% level) and positive coefficients, signaling
a direct relationship between the portfolio returns of small firms (with respect to size) and the
excess return of the market. The big size portfolios all have negative coefficients which are
statistically significant at different levels (between 1% and 5%). The BH and BL portfolios are
significant at 1% while the BM portfolio is significant at 5% level. These negative relationships
indicate that the returns of big size portfolios are inversely related to that of the excess market
returns. This finding is consistent with Fama and French (1996) who show that small firms
load positively and big firms load negatively on SMB factor. The Book-to-Market equity (BE/
ME) factor coefficients (hp) are all statistically significant and different from zero at 1% level
for all the portfolios except for the BM portfolio which is statistically significant at 5% level.
Besides, BH, BM, SH and SM portfolios have positive factor loading on the HML. In addition
to the direct relationship that exist between these portfolios HML coefficients and excess market
returns, medium to high BE/ME portfolios are however associated with distress due to
persistently low earnings on book equity which will eventually result in low stock prices. On
the other hand BL and SL portfolios have negative factor loadings indicating an inverse
relationship with excess market returns, but low BE/ME portfolios are characterized with growth
stocks with persistently high earnings on book equity that result in high stock prices. This
 Table II
246
Regression Results for Fama and French Three Factor Model and Capital Asset Pricing Model (January 2003 to December 2012)

Three Factor Model: Rp Rf = p + p (Rm-Rf) + Sp SMB + hp HML + p

CAPM: Rp Rf = p + p (Rm Rf) + p
Three Factor Model CAPM
Portfolios p p Sp Hp Adj.R2 D.W p p Adj.R2 D.W.
BH -1.5746 0.8476 -0.2657 0.7324 0.77 2.40 0.7298 1.2195 0.58 2.24
T-ratio [P.V] -2.59[0.01]** 9.59 [0.00]* -3.06 [(0.00]* 6.34 [0.00]* 0.93 [0.35] 12.82 [0.00]*
BM -0.0876 0.9589 -0.1690 0.1234 0.75 2.01 0.4636 1.0779 0.73 1.92
T-ratio [P.V] -0.17 [0.86] 13.75 [0.000]* -2.33 [0.02]** 1.90 [0.05]* 0.94 [0.34] 18.03 [0.00]*
BL -0.6853 0.9071 -0.2750 -0.3513 0.74 2.11 -1.2637 0.9110 0.64 2.23
T-ratio [P.V] -1.46 [0.14] 14.26 [0.000]* -4.15 [0.00]* -5.95 [0.00]* -2.45 [0.01]** 14.52 [0.00]*
SH -0.1727 0.9280 0.9068 0.6140 0.80 2.23 0.2800 0.7280 0.32 1.68
T-ratio [P.V] -0.37 [0.70] 14.89 [0.000]* 13.96 [0.00]* 10.61 [0.00]* 0.35 [0.72] 7.54 [0.00]*
SM -1.1128 0.9169 0.4670 0.1926 0.63 1.97 -1.2097 0.7715 0.50 1.59
T-ratio [P.V] -2.06 [0.04]** 12.55 [0.00]* 6.13 [0.00]* 2.84 [0.00]* -2.08 [0.03]** 10.90 [0.00]*
SL -1.0620 0.8685 0.9162 -0.3022 0.58 2.26 -3.0694 0.3495 0.09 1.71
T-ratio [P.V] -1.7 [0.09]*** 9.01 [0.000]* 8.84 [0.00]* -3.19 [0.00]* -3.78 [0.00]* 3.54 [0.00]*
Source: Authors Computation, (2014) with E-view 7.0 [Appendices I and II]
NB: *, ** & *** represent significance at 1%, 5% and 10% respectively
Ajao, M. Gabriel and Igbinosa, Sunday
A Comparative Analysis of the Three-Factor and the Capital Asset Pricing Models... 247

finding is equally consistent with Fama and French (1993, 1996) and Drew and Veeraraghavan
(2002) who find that high BE/ME firms load positively and low BE/ME firms load negatively
on HML factor. The robustness of the model is further supported by the values of the adjusted
coefficient of determination ( R 2 ) which ranges from 0.58 to 0.80 with an average of 0.71. So
on the average 71% of the variations in portfolio returns on the NSE is captured by the three
factor model during the period under consideration.
For the CAPM, the intercept coefficients (p) are statistically significant and different
from zero at 5% level for three portfolios. These results imply that BL, SM and SL portfolios
are not fully explained by the factors contained in the full period CAPM. The coefficients of
the intercept of BH, BM and SH portfolios are positive and not significant even at 10%. The
market factor coefficients (p) are all positive and significant at 1% level for all the six portfolios.
The results indicate that there is direct relationship between stock returns and beta. This finding
is consistent with previous studies: Osamwonyi and Asein (2012), Tafamel (2012) in which
they find the existence of positive risk-return relationship.
In comparing the results of the two models (three factor model and CAPM) above, we
adopt the adjusted R 2 criterion, it can be affirmed that the three factor model captures better
common variation in stock returns than the CAPM. Indeed for the three factor model, the
adjusted R 2 for the six portfolios ranges from 0.58 to 0.80 with an average adjusted R 2 of
0.71 while the adjusted R 2 for the CAPM in the six portfolios ranges from 0.09 to 0.73 with an

Figure I: Three Factor Model vs CAPM (Adjusted R-squared)

Source: Authors Computation, 2014

248 Ajao, M. Gabriel and Igbinosa, Sunday

average adjusted R2 of 0.47. Moreover, as can be observed in Figure I below, the individual
portfolios to portfolio comparison of the six portfolios for the models further shows that the
adjusted R2 in each of the three factor model portfolio is higher than the corresponding
adjusted R2 in CAPM portfolio. This result suggests that the three factor model captures the
common variation in stock returns better than the CAPM model. However, the relevance of
market beta cannot be replaced by either size or BE/ME factor as indicated by the positive
and statistically significant values of beta coefficient (p) in both the three factor and the
CAPM regression results. This finding is consistent with Fama and French (1993); Bhatnagar
and Ramlogan (2012); Ajili (2002); Charitou and Constantinidis (2004) and Firozjaee and
Jelodar (2010).
We also checked for the residual autocorrelation using the Durbin-Watson (DW) statistics
(Durbin and Watson, 1950, 1951 a, b). The DW statistic test for first order serial autocorrelation
usually takes values close to 2. An observation of our six portfolios regression (Table II)
indicates that the values of the DW statistic ranges between 2.01 and 2.40 for the three factor
model, while it ranges between 1.59 and 2.24 for the CAPM except for the SM portfolio with
a DW statistic value of 1.97 in the three factor model and for the CAPM, portfolios BM, SH,
SM and SL with their respective DW statistic of 1.92, 1.68, 1.59 and 1.71 which can all be
approximated to 2. This is a clear evidence of absence of first order autocorrelation in the
estimates.

4.3. Findings
In this study, we investigate the risk factors in returns and asset pricing in the Nigerian stock
market. We empirically study the ability of commonly proposed risk factors (market beta, market
equity (size) and the ratio of the market value of equity to book value of equity (BEME) to
predict monthly stock returns and asset prices in the Nigerian stock market. Specifically we test
the Capital Asset Pricing Model and the Three Factor Model of Fama and French (1993) on a
sample of sixty-eight (68) stocks for a period of one hundred and twenty (120) months from
January 2003 to December 2012. Findings from our empirical analysis can be summarized in
the following points:
The Capital Asset Pricing Models (CAPM) through the market betas () explain the
cross section of expected returns of stock quoted on the Nigerian Stock Exchange.
This result is similar to those of other studies Brailsford and Josev (1997); Fama and
French (2004), Osamwonyi and Asein (2012) and Tafamel (2012).
The Fama and French Three Factor Model holds in the Nigerian capital market and it
explains the variation of expected returns of quoted stocks on the Nigerian Stock Market
better than the Capital Asset Pricing Model (CAPM). This finding is consistent with
the findings of Fama and French (1993) in the US stock markets; Ajili (2002) in the
French market; Shum and Tang (2005) in three Asian emerging markets (Hongkong,
Singapore and Taiwan; Firozjaee and Jelodar (2010) in the Tehran Stock Exchange;
Bundoo (2011) in Mauritius market; and Bhatnagar and Ramlogan (2012) in the United
Kingdom.
A Comparative Analysis of the Three-Factor and the Capital Asset Pricing Models... 249

4.4. Conclusion and Recommendations

On the basis of the empirical findings above, it is very clear that the Fama and French three
factor model provides significant improvement over the conventional one factor CAPM in
capturing and explaining the cross section of expected returns on quoted stocks in the Nigerian
stock market. We have basically compared the three factor model with the famous asset pricing
model, the CAPM and our findings overwhelmingly supported the three factor model as a
better asset pricing model which explains the cross section of expected return of quoted stocks
in the Nigerian stock market. In other words, market beta, firm size (market equity) and firm
book-to-market equity ratio (BE/ME) are significant factors affecting stock returns in the capital
market. Though this finding is consistent with of previous studies conducted in other economies,
the results must be interpreted with caution, as they may be sample specific. Besides, the small
number of quoted companies in the Nigerian stock market coupled with high volatility of returns
in the sample period may have influenced the findings of this study. Similarly, the small sample
size may make it difficult to form portfolios of well diversified stocks, and this may have also
influenced the robustness of the findings.
Since the findings from our analysis reveal that the cross section of expected returns in the
Nigerian Stock Market are better captured and described by the Fama and French three factor
model than by the traditional Capital Asset Pricing Model. It is hereby recommended that fund
managers, investors and researchers should be cautious in their use of CAPM as an asset
pricing model due to its limitation as a single factor model which does not capture in totality
the variations of factors affecting asset pricing and returns.

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Appendix I: OLS estimation of the Fama and French Three Factor Model
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