Book-to-Market Effect and Fama French Model in Bear – Bull Markets:
Abstract: Book-to-market Effect is one of the facts that cannot be explained by market factor in CAPM. The premium between the returns on high and low B/M portfolios is asserted to be the compensation for the associated risk, therefore HML risk factor was formed in order to capture the risk premium in the studies of Fama and French (1992, 1993, 1996). In my study, I show that B/M effect is essentially relevant in bear markets. The mean monthly premium is found to be 0,54% (annual 6,68%) for the whole period, July 1963 – February 2006. On the other hand, the analyses of the premium in bear and bull market conditions give the respective results of 1,87% (24,9% per annum) for bear markets and 0,14% (1,69% per annum) for bull markets. High bear market mean premium and insignificant bull market premium reflect that the underlying risk is associated with mainly bear market characteristics and priced through only bear markets. Assuming that the associated risk increases in bear market condition, this finding provides evidence in favor of the risk based explanation for the premium rather than an irrational markets explanation. Furthermore, observing the risk exposures in bear and bull markets leads to the examination of 3 Factor Fama French model through both market types. 3 Factor model uses constant exposures to risk underlying the HML premium. However, it is seen that, for 10 out of 25 Fama French portfolios, HML coefficients are different in bear – bull markets at 1% significance level. For all of these portfolios, bull market coefficients are smaller than the ones in bear markets resulting in certain misevaluation of risk exposures and excess returns.
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