Testing the Fama and French three-factor model : New Zealand evidence

Abstract

The Capital Asset Pricing Model (CAPM) posits that the expected return on an asset, for instance stocks, is linearly and positively related to beta. The model also holds that beta sufficiently explains any variation in returns. However, a number of studies have demonstrated that there exist other variables that significantly explain the cross-section of expected returns; for instance firm size, book-to-market equity (BTM), earnings-price ratio, and cash flow yield. Subsequently, Fama and French (1992) find that size and BTM together suffice to explain the cross-section of returns, and that the relationship between beta and returns is virtually flat after controlling for size. Fama and French (1993, 1996, 1998) go on to develop and test a multifactor model with return on market, size and BTM factors, and find that their three-factor model is able to capture most of the anomalies found in the literature. Both size and BTM effects have been found in the cross-section of stock returns on the New Zealand Stock Exchange (NZSE) (Bryant, 1997).

This study performs tests of the FF three-factor model using New Zealand (NZ) data for the sample years July 1990 to June 2000. Stocks are sorted into nine size-BTM portfolios. The findings indicate that the model has low explanatory power for both value-weighted and equal-weighted excess returns in NZ. None of the slopes for the three factors are found to be consistently significant across the nine portfolios tested, while the intercepts are shown to be significantly different from zero. However, there is evidence to suggest that one or more of the factors tested may have a significant relationship with the returns on certain size and/or BTM portfolios.