Risk Management

Lecture 4-1: Multi-Factor Asset Pricing Model

Chen Tong

SOE & WISE, Xiamen University

October 10, 2024

Chen Tong (SOE&WISE) Risk Management October 10, 2024 1 / 40

Review of CAPM Anomaly

▶ The cross-section of average returns on U.S. common stocks shows

little relation to the market βs.

▶ Stattman(1980), Banz(1981), Bhandari(1988), Basu(1983), and

Rosenberg, Reid, and Lanstein (1985).

▶ Variables that have no special standing in asset-pricing theory show

reliable power to explain the cross-section of average returns.
▶ size: ME (market equity), stock price times number of shares
▶ leverage
▶ earnings/price (E/P)
▶ book-to-market equity, BE/ME (the ratio of the book value of a
firms common stock to its market value)

Chen Tong (SOE&WISE) Risk Management October 10, 2024 2 / 40

Fama and French (1992)

Chen Tong (SOE&WISE) Risk Management October 10, 2024 3 / 40

Fama and French (1992)

▶ Fama and French (1992) studied the joint roles of market β, size,
E /P, leverage, and book-to-market equity in the cross-section of
average stock returns.
▶ β (the slope in the regression of a stocks return on a market return)
has little information about average returns.
▶ Used alone, size, E/P, leverage, and book-to-market equity have
explanatory power.
▶ In combinations, size (ME) and book-to-market equity (BE/ME)
seem to absorb the apparent roles of leverage and E /P in average
returns.

Chen Tong (SOE&WISE) Risk Management October 10, 2024 4 / 40

Fama and French (1993)

Chen Tong (SOE&WISE) Risk Management October 10, 2024 5 / 40

Descriptive Statistics

Chen Tong (SOE&WISE) Risk Management October 10, 2024 6 / 40

Interpretations

▶ The portfolios in the smallest size quintile have the most stocks and
the smallest fractions of value. The opposite is true for the largest
size quintile.

▶ The portfolio of stocks in both the largest size and lowest BE /ME
quintiles (big successful firms) alone accounts for more than 30% of
the combined value of the 25 portfolios.

▶ In every size quintile but the smallest, both the number of stocks
and the proportion of total value accounted for by a portfolio
decrease from lower- to higher- BE /ME portfolios.

Chen Tong (SOE&WISE) Risk Management October 10, 2024 7 / 40

Descriptive Statistics (Table 2)

Chen Tong (SOE&WISE) Risk Management October 10, 2024 8 / 40

Interpretations

▶ There is a negative relation between size and average return, and

there is a stronger positive relation between average return and
book-to-market equity.

▶ In all but the lowest- BE /ME quintile, average returns tend to

decrease from the small- to the big-size portfolios.

▶ The relation between average return and book-to-market equity is

more consistent. In every size quintile, average returns tend to
increase with BE /ME .

Chen Tong (SOE&WISE) Risk Management October 10, 2024 9 / 40

Stock Market Factors

▶ Book-to-market ratio.
▶ Firms that have high BE /ME (a low stock price relative to book
value) tend to have persistent low earnings on assets.
▶ HML is the difference, each month, between the simple average of
the returns on the two high-BE /ME portfolios (S/H and B/H) and
the average of the returns on the two low- BE /ME portfolios (S/L
and B/L).

▶ Size.
▶ Controlling for book-to-market equity, small firms tend to have lower
earnings on assets than big firms.
▶ SML is the difference between the returns on small- and big-stock
portfolios with about the same weighted-average BE /ME .

Chen Tong (SOE&WISE) Risk Management October 10, 2024 10 / 40

Factor construction

http://mba.tuck.dartmouth.edu/pages/faculty/ken.french/Data_Library/f-
f_factors.html

Chen Tong (SOE&WISE) Risk Management October 10, 2024 11 / 40

The Returns to be Explained

▶ Excess returns on 25 stock portfolios, formed on size (small to big, 5

groups) and book-to-market equity(low to high, 5 groups).
▶ Because we seek to determine whether the mimicking portfolios SMB
and HML capture common factors in stock returns related to size
and book-to-market equity.

▶ Excess returns formed on E /P (earnings/price) and D/P

(dividend/price).
- To check the robustness of our results on the ability of our
explanatory factors to capture the cross-section of average returns.

Chen Tong (SOE&WISE) Risk Management October 10, 2024 12 / 40

Time-series Regressions

▶ Regressions (monthly):
- Regressions that use the excess market return, RM − RF as
explanatory variables.
- Regressions that use SMB and HML, the mimicking returns for the
size and book-to-market factors, as explanatory variables.
- Regressions that use RM − RF , SMB and HML.

▶ We try to find the factors that best explain the stock returns.
Apparently the last regression works better than the former two, but
the two help explain why.

Chen Tong (SOE&WISE) Risk Management October 10, 2024 13 / 40

Regression that use RM − RF (Table 4)

Chen Tong (SOE&WISE) Risk Management October 10, 2024 14 / 40

Interpretations

▶ RM − RF does capture some common variation in stock returns (t

statistics).

▶ However, the market leaves much variation in stock returns that

might be explained by other factors.
▶ The only R 2 values near 0.9 are big-stock low-book-to-market
2
portfolios. For small-stock and high-BE/ME portfolios, most R
values are less than 0.8 or 0.7.
▶ These are the stock portfolios for which the size and book-to-market
factors, SMB and HML, will have their best shot at showing
marginal explanatory power.

Chen Tong (SOE&WISE) Risk Management October 10, 2024 15 / 40

Regression that use SML and HML (Table 5)

Chen Tong (SOE&WISE) Risk Management October 10, 2024 16 / 40

Interpretations

▶ In the absence of competition from the market portfolio, SMB and

HML capture substantial time-series variation in stock returns.
▶ 20 of the 25 R 2 values are above 0.2 and eight are above 0.5.
Especially for the portfolios in the larger-size quintile.

▶ However, SMB and HML leave common variation in stock returns

that might be picked up by the market portfolio in table 4.

Chen Tong (SOE&WISE) Risk Management October 10, 2024 17 / 40

Regression that use RM − RF , SML and HML(Table 6)

Chen Tong (SOE&WISE) Risk Management October 10, 2024 18 / 40

Regression that use RM − RF , SML and HML(Table 6)

Chen Tong (SOE&WISE) Risk Management October 10, 2024 19 / 40

Interpretations

▶ The three stock-market factors capture strong common variation in

stock returns:

▶ β : The market β s for stocks are all more than 38 standard errors
from 0.

▶ SMB: The t-statistics on the SMB slopes for stocks are typically
large (greater than 4). Moreover, the slopes on SMB for stocks are
negatively related to size. In every book-to-market quintile, the
slopes on SMB decrease monotonically from smaller- to bigger-size
quintiles.

Chen Tong (SOE&WISE) Risk Management October 10, 2024 20 / 40

Interpretations (Continued)

▶ HML.
▶ Except for the second BE /ME quintile, where the slopes pass from
negative to positive, the HML slopes are more than 5 standard errors
from 0.
▶ In every size quintile of stocks, the HML slopes increase
monotonically from strong negative values for the lowest BE /ME
quintile to strong positive values for the highest-BE /ME quintile.

Chen Tong (SOE&WISE) Risk Management October 10, 2024 21 / 40

Interpretations (Continued)

▶ R2
▶ Large increase in R 2 compared to Table 4: typically greater than 0.9.
▶ For the smallest-size quintile, R 2 increases from values between 0.61
and 0.70 in table 4 to values between 0.94 and 0.97 in table 6.
▶ β.
▶ β in the smallest-size and lowest-BE /ME quintile and the
largest-size and highest-BE /ME are 1.40 and 0.89 in Table 4 , and
they are 1.04 and 1.06 respectively in Table 6.
▶ Adding SMB and HML collapses the βs for stocks toward 1.0: low
βs move up toward 1.0 and high βs move down. This is due to the
correlation between the market and SMB or HML.

Chen Tong (SOE&WISE) Risk Management October 10, 2024 22 / 40

Fama and French (1996)

Chen Tong (SOE&WISE) Risk Management October 10, 2024 23 / 40

Model Specification

▶ The expected excess return on portfolio i is,

E (Ri ) − Rf = bi (E (Rm ) − Rf ) + si E (SMB) + hi E (HML)

where E (Ri ) − Rf , E (SMB) and E (HML) are expected premiums,

and the factor sensitivities or loadings, bi , si , and hi , are the slopes
in the time-series regression.

Ri − Rf = αi + bi (RM − Rf ) + si SMB + hi HML + εi ,

Chen Tong (SOE&WISE) Risk Management October 10, 2024 24 / 40

Test the model on 25 portfolios

▶ This is the same as the previous three factor regression, but this
time we focus on the intercepts.
▶ If the three-factor model describes expected returns, the regression
intercepts should be close to 0.

Chen Tong (SOE&WISE) Risk Management October 10, 2024 25 / 40

The intercepts!

Chen Tong (SOE&WISE) Risk Management October 10, 2024 26 / 40

Interpretations

▶ The estimated intercepts say that the model leaves a large negative
unexplained return for the portfolio of stocks in the smallest size and
lowest BE /ME quintiles, and a large positive unexplained return for
the portfolio of stocks in the largest size and lowest BE /ME
quintiles. Otherwise the intercepts are close to 0.

Chen Tong (SOE&WISE) Risk Management October 10, 2024 27 / 40

The Power of Three Factor Model

▶ Fama and French(1996) argues that many of the CAPM

average-return anomalies are related, and they are captured by the
three-factor model in Fama and French (FF 1993).

▶ Lakonishok, Shleifer, and Vishny (LSV 1994) examine the returns on

sets of deciles formed from sorts on BE /ME , E /P, C /P, and
five-year sales rank.

Chen Tong (SOE&WISE) Risk Management October 10, 2024 28 / 40

The Power of Three Factor Model

Chen Tong (SOE&WISE) Risk Management October 10, 2024 29 / 40

Interpretation

▶ The regression intercepts are consistently small.

▶ The GRS tests never come close to rejecting the hypothesis that the
three-factor model describes average returns.
▶ Higher-C /P portfolios produce larger slopes on SMB and especially
HML. This pattern in the slopes is also observed for the BE /ME
and E /P deciles (not shown).
▶ Dividing an accounting variable by stock price produces a
characterization of stocks that is related to their loadings on HML.

Chen Tong (SOE&WISE) Risk Management October 10, 2024 30 / 40

The Power of Three Factor Model

Chen Tong (SOE&WISE) Risk Management October 10, 2024 31 / 40

Interpretation

▶ Low sales-rank stocks behave like distressed stocks. They have

stronger loadings on HML.

▶ Except for the highest sales-rank decile, however, the intercepts are
close to 0.

▶ This is important because sales rank is the only portfolio-formation

variable that is not a transformed version of stock price.

Chen Tong (SOE&WISE) Risk Management October 10, 2024 32 / 40

Fama and French (1995)

Chen Tong (SOE&WISE) Risk Management October 10, 2024 33 / 40

FF(1995)-Risk sources

▶ Fama and French (1995) show that book-to-market equity and

slopes on HML proxy for relative distress.
▶ Weak firms with persistently low earnings tend to have high BE /ME
and positive slopes on HML; strong firms with persistently high
earnings have low BE /ME and negative slopes on HML.
▶ Since loadings on HML proxy for relative distress, we can infer that
low BE /ME , E /P, and C /P are typical of strong stocks, while high
BE /ME , E /P, and C /P are typical of stocks that are relatively
distressed.

Chen Tong (SOE&WISE) Risk Management October 10, 2024 34 / 40

Four Factor Model

Carhart(1997) proposes a four-factor model for U.S. returns.

Rit − Rf = ai + bi [Rm,t − Rf ] + si SMBt + hi HMLt + wi WMLt + eit

▶ WML(t) is the difference between the month t returns on diversified

portfolios of the winners and losers of the past year.

▶ The four factor model explain the persistence in mutual fund

performance over short term horizons of 1-3 years. Some people
attribute the persistence to "hot hands: or common investment
strategies, but Carhart find, instead, this is because some mutual
funds just happen by chance to hold relatively larger positions in last
year’s winer stocks because hot-hands funds infrequently repeat their
abnormal performance.

Chen Tong (SOE&WISE) Risk Management October 10, 2024 35 / 40

Five Factor Model

▶ The three factor model may be an incomplete model for expected

return because its three factors probably miss much of the relations
between expected return and expected profitability and investment.

▶ Fama and French(2015) proposes a five-factor model for U.S.

returns: three factor + RMW (t) + CMA(t)

▶ RMW (t) is the difference between the returns on diversified

portfolios of stocks with robust and weak profitability; CMA(t) is
the difference between the returns on diversified portfolios of low and
high investment stocks, which we call conservative and aggressive.

Chen Tong (SOE&WISE) Risk Management October 10, 2024 36 / 40

Fama-MacBeth Regressions

▶ A regression modeling approach to estimate the premium awarded to

a particular factor by the market
▶ Used extensively in industry and academic asset pricing research
▶ Involves a two-stage approach
▶ Stage 1: A time series regression (one for each asset) to estimate the
sensitivity of an asset to a set of factors (or a special variable!)
▶ Stage 2: A cross-sectional regression (one for each time period) to
estimate the factor risk premia

Chen Tong (SOE&WISE) Risk Management October 10, 2024 37 / 40

Assumptions & Notations

▶ n assets (or portfolios)

▶ T time periods
▶ ri,t = return on asset/portfolio i during period t
▶ m factor series F1,t , F2,t , . . . , Fm,t

Chen Tong (SOE&WISE) Risk Management October 10, 2024 38 / 40

Stage 1 Regressions

▶ The Stage 1 regressions have the following form:

ri,t = αi + βi,F1 F1,t + . . . + βi,Fm Fm,t + ϵi,t , t = 1, . . . , T , ∀i

▶ Regressions of this form are run for each asset (or portfolio) in the
sample, so we have n time-series regressions in total.

▶ The output of this stage is a set of factor sensitivities

β̂i,F1 , β̂i,F2 , . . . , β̂i,Fm for each asset.

▶ Note that the "Factors" in Stage 1 could be any time series variable
that is supposed to influence asset/portfolio returns, including the
market index, economic variables such as inflation, quantitative
pricing variables such as value or momentum.

Chen Tong (SOE&WISE) Risk Management October 10, 2024 39 / 40

Stage 2 Regressions

▶ Stage 2 regressions are cross-sectional for a given period and

produce factor risk premia estimates
▶ For each periods t, run the following cross-sectional regression:

ri,t = λ0,t + λ1,t β̂i,F1 + λ2,t β̂i,F2 + . . . + λm,t β̂i,Fm + εi,t , i = 1, . . . , n

▶ The dependent variable is the cross-section of asset/portfolio returns

for each period, while the previously estimated factor sensitivities
serve as the independent variables. Thus the total number of
regressions is T .
▶ The regression produces T estimates λ̂k,t of the premium of factor k
for all period t, therefore FM methodology proposed to use the
T
average of these estimates, T1 ∑t=1 λ̂k,t , as the final estimated value
of factor k risk premium.

Chen Tong (SOE&WISE) Risk Management October 10, 2024 40 / 40