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Three Factor Asset Pricing Model

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Three Factor Asset Pricing Model
Student name: Umar Abdullaev

Proposed research topic:

The implication of conditional betas on the Fama-French three factor model

Introduction CAPM has been an active area of research over the past half century since the introduction of Sharpe development of the capital asset pricing model. Much progress has been made in the early years on the linear relationship between expected return and beta(Black, Jensen and Scholes 1972 and Fama and MacBeth 1973). Later studies however show weak empirical evidence on these relationships. Since then, although extended versions of CAMP have been introduced such as CAPM with higher-order co-moments and CAPM conditional on time-varying volatility little research has been done in the effect of up and downside risk on the three factor model proposed by Fama and French in 1993 and 1996.

The research aims to make a contribution to the understanding of the complicated version of CAPM through adding up and down betas to the three factor model for two main reasons. First, this area of study is little researched and second the single beta value is rarely accepted by many academics and practitioners to explain portfolio returns, suggesting that downside or upside risk may be more appropriate measure of portfolio risk than the single beta.

Since the three factor model is important to estimate the cost of equity capital and now widely used in empirical research, the study will primary be concerned with the examination of three factor model that incorporates conditional betas and test weather these factors are priced. Although there is published evidence on the significantly positive (negative) beta-return relationship in the up(down) markets(Pettengill, Sundaram and Mathur, 1995) and on the usefulness of two non-market risk factors SMB(the difference between the return on a portfolio of small stocks and the return on a portfolio of large stocks) and HML(the difference between the return on a portfolio of



References: 1. Eugene F. Fama and Kenneth R. French, January 2004, “The Capital Asset Pricing Model: Theory and Evidence”; 2. Daniel FS Choi, Daniel JP Chai and Tian Yong Fu ”The conditional relation between beta and returns”: the New Zealand Case”; 3. Richard A.Brealey and Stewart C. Myers, Sixth Edition “Principles of Corporate Finance”; 4. Don U.A. Galagedera, “A review of Capital Asset Pricing Models”; 5. Patricia Fraser, Foort Hamelink, Martin Hoesli, and Brian MacGregor “Time-varying betas and cross-sectional return-risk relation: evidence from the UK”; 6. Ou Hu, July 2003, “Forecasting ability of the Fama and French three-factor model-implications for capital budgeting”; 7. Phuong Doan “Asset allocation under higher moments”; 8. Don U A Galagederea, Darren Henry, Param Silvapulle, “Conditional relation between higher co-moments and stock returns: evidence from Australian data”; 9. Elroy Dimson and Massoud Mussavian, January 2000, “Three centuries of asset pricing”;

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