FI4003 Empirical Methods in Finance

Course work: Asset pricing models

Background:   Fama and French (1992, 1993) extended the traditional cap- ital asset pricing model (CAPM) to include firm size and book-to-market effects as explanatory factors for stock returns.1  A time-series version of the three-factor Fama-French model can be written as2                                                             (1)        rit − rft  = αi + β1i(rmt − rft ) + β2iSMBt + β3iHMLt + εit                      where rit  is the return of stock i in period t, rft  is the risk-free rate, rmt  is the return of the market portfolio, SMBt  is the additional return received by investors from investing in companies having a low market capitalization, and HMLt , is the return provided to investors for investing in companies having high book-to-market values.  The error term εit  is assumed to have mean zero. The coefficients βi  = [β1i,β2i,β3i] then capture the sensitivity of the stock’s return with respect to the three market factors.

Task and coverage:   The spreadsheet French 3 Factor daily .xlsx con- tains daily data on rmt − rft , SMBt , HMLt , and rft  for the period 2020-01-2 to 2022-08-30.3    For your report download daily returns for at least three stocks or exchange traded funds (ETFs) which are traded on the NYSE to complement the market data provided in the spreadsheet.  For the selected assets implement the time-series version of the CAPM and three-factor Fama- French model and interpret the estimation results. You should pay particular attention to the question if your model estimates support the Fama-French model over the traditional CAPM.

The report should have the following the structure

1. Introduction including background/motivation and literature review

2. Empirical approach/methodology

3. Description of the dataset

4. Empirical results

5. Summary/conclusions with discussion of possible extensions

Generally a report of this type should have some circularity to it. If you refer to something at the start then you should refer to this concept at the end, to ensure the work is complete.

General instructions

You should be certain that you fully understand the task.  If you want to check your understanding, please discuss it with me.4

Your report should have a large portion of it devoted to what you do, i.e., your analysis, not what others do (unlike a regular piece of course work), although some recognition of what other people have done is important (and again, you may be drawing inspiration directly from these papers).

Your report should have a maximum of 1,500 words, the table of contents and the references do not count towards this word limit. 1,500 words correspond approximately to four to five normally spaced pages in a Word document with the font Times Roman at 12pts.  References should be in the Harvard style.

The assignment carries 20% of the total marks in FI4003 Empirical Methods in Finance. The report will be assessed according to the Common Grading Scale (CGS). The Feedback Sheet provides further details on the marking grid.