CAPM vs.

Fama-French 3
factor model.
Empirical approach.
 Agenda

 First will be analyzed CAPM performance over 25

portfolios in two time periods:
Between 1932 and 1962

After 1962

 Second step will be to estimate 3 factor FF model

on 1963-1993 period and using the results to
forecast and analyze the performance after 1993.
 CAPM intercepts and their
significance
Between 1932 and 1962 After 1963
Book to Market Equity Book to Market Equity
Alpha quintiles Alpha quintiles
Low 2 3 4 High Low 2 3 4 High
Small -0.33 -0.63 0.08 0.36 0.40 Small -0.47 0.13 0.21 0.49 0.56
2 -0.04 0.12 0.04 0.21 0.27 2 -0.25 0.14 0.33 0.42 0.43
Size

Size
3 0.06 0.14 0.12 0.12 -0.10 3 -0.19 0.21 0.23 0.39 0.50
4 0.06 0.07 0.14 0.04 -0.19 4 -0.04 0.04 0.18 0.38 0.28
Big -0.03 -0.08 0.14 -0.17 0.07 Big -0.03 0.04 0.11 0.05 0.20

Book to Market Equity Book to Market Equity

t-stat t-stat
quintiles quintiles
Alpha Alpha
Low 2 3 4 High Low 2 3 4 High
Small -0.50 -1.43 0.23 1.11 1.00 Small -2.47 0.81 1.58 3.56 3.84
2 -0.17 0.53 0.21 0.92 0.88 2 -1.71 1.23 3.01 3.94 3.22
Size

Size
3 0.30 1.07 0.93 0.67 -0.38 3 -1.63 2.31 2.65 4.06 4.05
4 0.62 0.78 1.11 0.26 -0.70 4 -0.44 0.54 2.14 4.24 2.32
Big -0.40 -1.07 1.28 -1.15 0.25 Big -0.40 0.59 1.30 0.49 1.51

One of the assumptions of CAPM – “Alpha values to be zero” is violated after 1963
(as we can see from t statistics – colored in red).
 CAPM betas and their
significance
Between 1932 and 1962 After 1963
Book to Market Equity Book to Market Equity
Beta quintiles Beta quintiles
Low 2 3 4 High Low 2 3 4 High
Small 1.84 1.63 1.65 1.49 1.68 Small 1.42 1.24 1.11 1.02 1.07
2 1.23 1.34 1.38 1.43 1.63 2 1.40 1.17 1.06 1.01 1.13
Size

Size
3 1.24 1.14 1.27 1.36 1.67 3 1.32 1.12 1.01 0.96 1.06
4 0.97 1.11 1.24 1.33 1.73 4 1.23 1.07 1.01 0.96 1.09
Big 0.92 0.95 1.06 1.31 1.54 Big 0.98 0.94 0.85 0.88 0.96

Book to Market Equity Book to Market Equity

t-stat t-stat
quintiles quintiles
Beta Beta
Low 2 3 4 High Low 2 3 4 High
Small 17.93 23.55 31.11 28.98 26.56 Small 33.42 33.06 36.24 33.31 32.34
2 29.66 37.42 42.04 38.97 34.14 2 43.32 45.04 43.18 42.21 37.31
Size

Size
3 42.75 55.73 61.54 49.15 40.14 3 49.80 55.79 50.58 44.48 38.20
4 67.21 77.47 60.77 50.79 41.53 4 60.49 65.06 53.67 47.79 40.62
Big 84.69 85.22 60.27 54.66 33.68 Big 68.74 69.08 46.27 40.23 33.07

All betas are significant as it should be.

 CAPM fitted return and R2

Between 1932 and 1962 After 1963

Book to Market Equity Book to Market Equity
fitted fitted
quintiles quintiles
return return
Low 2 3 4 High Low 2 3 4 High
Small 1.60 1.39 1.24 1.16 1.19 Small 1.14 1.04 0.97 0.93 0.95
2 1.62 1.34 1.20 1.15 1.27 2 1.13 1.01 0.95 0.92 0.98

Size
Size

3 1.53 1.30 1.16 1.10 1.19 3 1.09 0.98 0.92 0.90 0.95
4 1.44 1.25 1.17 1.09 1.21 4 1.04 0.96 0.92 0.89 0.96
Big 1.15 1.10 0.99 1.01 1.08 Big 0.91 0.88 0.84 0.86 0.90

Book to Market Equity Book to Market Equity

2 2
R quintiles R quintiles
Low 2 3 4 High Low 2 3 4 High
Small 0.46 0.60 0.72 0.69 0.66 Small 0.63 0.63 0.67 0.63 0.62
2 0.70 0.79 0.83 0.80 0.76 2 0.74 0.76 0.74 0.73 0.68
Size
Size

3 0.83 0.89 0.91 0.87 0.81 3 0.79 0.83 0.80 0.75 0.69
4 0.92 0.94 0.91 0.87 0.82 4 0.85 0.87 0.82 0.78 0.72
Big 0.95 0.95 0.91 0.89 0.75 Big 0.88 0.88 0.77 0.71 0.63

R2 indicates the proportion of the variance in the dependent variable that is

predictable from the independent variable(s) and it’s getting lower after 1963.
 Relation between
predicted return and betas
1.60

1.40

1.20

1.00

0.80
Beta
0.60 Predicted return

0.40

0.20

0.00
 FF 3 factor model
based on1963-1993 period
t-stat t-stat t-stat t-stat Retur Fitted
Alpha Beta HML SMB R2
Alpha Beta HML SMB n return
SMALL.LoBM -0.40 -3.72 1.04 39.49 -0.27 -6.44 1.42 36.78 0.85 0.72 0.93 The results show pretty
ME1.BM2
ME1.BM3
-0.12 -1.59 0.97 50.49
-0.09 -1.51 0.93 60.72
0.09
0.25
3.04 1.29 45.97 1.24 0.83
9.94 1.16 51.36 1.29 0.86
0.95
0.96
clear that:
ME1.BM4 0.07 1.17 0.89 59.09 0.39 15.95 1.11 50.43 1.50 0.89 0.96
SMALL.HiBM 0.08 1.28 0.95 58.03 0.64 23.90 1.20 49.88 1.68 1.07 0.96
• Most of the Alphas are
ME2.BM1 -0.14 -1.73 1.10 54.43 -0.48 -14.64 1.01 34.29 0.92 0.53 0.96 insignificant
ME2.BM2 -0.02 -0.32 1.02 60.30 0.02 0.72 0.92 37.27 1.22 0.72 0.96 • All of the Betas, SMB and
ME2.BM3 0.13 2.12 0.96 61.30 0.22 8.79 0.84 36.57 1.43 0.76 0.96
ME2.BM4 0.13 2.14 0.97 64.42 0.47 19.39 0.70 31.92 1.51 0.86 0.95 most of HML are significant
ME2.BM5 0.06 0.91 1.07 65.63 0.70 26.39 0.85 35.63 1.64 1.05 0.96 • The R2 is high for all of the
ME3.BM1 -0.02 -0.30 1.10 61.30 -0.45 -15.35 0.71 26.92 0.97 0.46 0.96
ME3.BM2 0.11 1.61 1.02 58.21 0.04 1.49 0.62 23.89 1.29 0.64 0.94 portfolios.
ME3.BM3 -0.02 -0.32 0.97 54.71 0.31 10.81 0.54 20.86 1.23 0.73 0.93
ME3.BM4 0.12 1.81 0.97 60.07 0.49 18.58 0.45 19.25 1.44 0.79 0.94
ME3.BM5
ME4.BM1
0.06
0.13
0.73
1.86
1.06 52.40
1.06 59.32
0.71 21.46
-0.45 -15.44
0.64 21.54
0.30 11.42
1.58
1.00
0.99
0.33
0.93
0.95
In summary: we can
ME4.BM2
ME4.BM3
-0.14
0.00
-1.74
0.05
1.07 53.87
1.04 53.42
0.04 1.16
0.31 9.61
0.27 9.15
0.24 8.33
0.95
1.21
0.56
0.68
0.92
0.91
conclude that FF 3
ME4.BM4
ME4.BM5
0.06
-0.01
0.74
-0.07
1.04 53.07
1.15 47.26
0.55 17.46
0.71 18.12
0.21 7.19
0.36 10.04
1.37
1.48
0.78
0.95
0.91
0.89
factor model is over
BIG.LoBM
ME5.BM2
0.20
0.00
2.98
-0.03
0.96 58.10
1.02 59.46
-0.45 -16.87
-0.01 -0.53
-0.20 -8.15
-0.20 -8.04
0.87
0.91
0.14
0.38
0.93
0.92
performing CAPM.
ME5.BM3 -0.06 -0.65 0.97 44.65 0.21 6.08 -0.28 -8.73 0.92 0.45 0.85
ME5.BM4 -0.10 -1.43 1.00 56.50 0.55 19.14 -0.18 -7.01 1.09 0.66 0.90
BIG.HiBM -0.13 -1.20 1.03 36.98 0.79 17.50 -0.04 -0.97 1.23 0.83 0.81
FF3: Actual vs. Predicted return
in period 1963-1993
1.80

1.60

1.40

1.20

1.00

0.80 Actual Return

Predicted return
0.60

0.40

0.20

0.00
FF3 performance in forecasting
Difference b/n Error as a
Actual Forecast
return return
first two
columns
% from
Actual
Our guideline will be %
SMALL.LoBM 0.43 0.84 -0.41 -94.53% error. We should consider
ME1.BM2
ME1.BM3
1.09
1.05
0.85
0.84
0.24
0.20
21.99%
19.48%
the fact that the forecast
ME1.BM4
SMALL.HiBM
1.31
1.29
0.84
0.92
0.47
0.37
35.73%
28.61%
period includes several
ME2.BM1 0.83 0.79 0.04 4.66% crises (dot com – 2000,
ME2.BM2 1.06 0.82 0.23 21.86%
ME2.BM3
ME2.BM4
1.07
1.11
0.82
0.85
0.25
0.27
23.35%
23.93%
financial – 2008) and it’s
ME2.BM5
ME3.BM1
1.12
0.80
0.95
0.77
0.17
0.03
15.17%
3.41%
normal to have some
ME3.BM2
ME3.BM3
1.05
1.05
0.80
0.80
0.25
0.25
24.16%
23.51%
deviation. The avg. error is
ME3.BM4
ME3.BM5
1.08
1.27
0.82
0.92
0.26
0.35
24.15%
27.31%
24.02%. Some of the results
ME4.BM1
ME4.BM2
1.00
1.05
0.71
0.78
0.29
0.27
29.30%
25.46%
(Ex: -94.53% or 4.66%)
ME4.BM3
ME4.BM4
0.96
1.13
0.81
0.84
0.15
0.30
16.07%
26.07% need additional investigation
ME4.BM5 0.93 0.93 -0.01 -0.79%
BIG.LoBM 0.89 0.60 0.29 32.89% before we can interpret
ME5.BM2 0.93 0.70 0.23 24.88%
ME5.BM3 0.96 0.70 0.27 27.58% them.
ME5.BM4 0.66 0.78 -0.12 -18.26%
BIG.HiBM 0.91 0.85 0.07 7.36%
FF3: Actual vs. Estimated return
after 1993
1.40

1.20

1.00

0.80

Actual
0.60 return
Prognosed
return
0.40

0.20

0.00