Cross-Section of Stock Returns: : Conditional vs. Unconditional and Single Factor vs. Multifactor Models

Abstract: The cross-sectional variation of stock returns used to be described by the Capital Asset Pricing Model until the early 90‟s. Anomalies, such as, book-to-market effect and small firm effect undermined CAPM‟s ability to explain stock returns and Fama & French (1992) have shown that simple firm attributes, like, firm size and book-to-market value can explain the returns far better than Beta. Following Fama & French many other researchers examine the explanatory powers of CAPM and other asset pricing models. However, most of those studies use US data. There are some researches done in different countries than US, however more out-of-sample studies need to be conducted. To our knowledge there are very few studies using the Swedish data and this thesis contributes to that small pool of studies. Moreover, the studies testing the CAPM use the unconditional version of the model. There are some papers suggesting the use of a conditional CAPM that would exhibit better explanatory powers than the unconditional CAPM. Different ways of conditioning the CAPM have been proposed, but one that we think is the least complex and possible to make use of in the business world is the dual-beta model. This conditional CAPM assumes a different relationship between beta and stock returns during the up markets and down markets. Furthermore, the model has not thoroughly been tested outside the US. Our study is the first to use the dual-beta model in Sweden. In addition, the momentum effect has lately been given some attention and Fama & French‟s (1993) three factor model has not been able to explain the abnormal returns related to that anomaly. We test the Fama & French three factor model, CAPM and Carhart‟s four factor model‟s explanatory abilities of the momentum effect using Swedish stock returns. Ultimately, our aim is to find the best model that describes stock return cross-section on the Stockholm Stock Exchange. We use returns of all the non-financial firms listed on Stockholm Stock Exchange between September, 1997 and April, 2010. The number of companies included in our time sample is 366. The results of our tests indicate that the small firm effect, book-to-market effect and the momentum effect are not present on the Stockholm Stock Exchange. Consequently, the CAPM emerges as the one model that explains stock return cross-section better than the other models suggesting that Beta is still a proper measure of risk. Furthermore, the conditional version of CAPM describes the stock return variation far better than the unconditional CAPM. This implies using different Betas to estimate risk during up market conditions and down market conditions.