An Exploratory Investigation of the Firm Size Effect

Journal

of Financial

Economics

14 (1985) 451-471.

North-Holland

AN EXPLORATORY INVESTIGATION THE FIRM SIZE EFFECT * K. C. CHAN
Ohio State Universiry, Columbw, OH 43210, USA

OF

Nai-fu CHEN

and David A. HSIEH

University of Chicago, Chicago, IL 60637, USA Received August 1983, final version received April 1985 We investigate the firm size effect for the period 1958 to 1977 in the framework of a multi-factor pricing model, The risk-adjusted difference in returns between the top five percent and the bottom five percent of the NYSE firms is about one to two percent a year, a drop from about twelve percent per year before risk adjustment. The variable most responsible for the adjustment is the sensitivity of asset returns to the changing risk premium, measured by the return difference between low-grade bonds and long-term government bonds.

1. Introduction
The ‘firm size’ effect was documented by Banz (1981) and Reinganum (1981). In their studies, small firms had higher average returns than large firms even after adjusting for risk via the Capital Asset Pricing Model (CAPM). Therefore, their results can be considered a rejection of the joint hypotheses that the CAPM is correct and that the market is efficient. In a recent empirical study of the Arbitrage Pricing Model (APT),’ Chen (1981, 1983) found that the firm size effect is essentially captured by the factor loadings of the APT. In his study portfolios of different size firms did not have significantly different average returns after adjusting for factor risks. Chen’s results are consistent with the hypotheses that risk is the explanation for the firm size effect and that the market is efficient.
*We thank Eugene Fama, Merton Miller, and Myron Scholes for their many comments and suggestions, Roger Ibbotson for providing us with some of the necessary data, and the Center for Research in Security Prices for financial support. We also benefited from discussions with John Abowd, Rolf Banz,

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