Problem 1: CAPM versus Fama and French 3-factor Model
A. CAPM:
Select a company from the S&P 500 index. Download monthly adjusted closing prices from the Bloomberg Terminal for S&P 500 and the company over the period January 2007 -December 2017. For the same period download the monthly excess return on one-month T-bills from Professor Kenneth French's website
Once the data are obtained perform the following steps:
(i) Calculate the log returns and the excess return for S&P 500 and the company (You may wish to recreate the table headings below):
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Monthly Returns Excess Returns
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Date
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S&P 500
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Company
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S&P 500
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Company
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Risk Free Rate
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S&P 500 returns
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Company returns - Risk-free rate
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Adj Close
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Returns
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Returns
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Returns
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-
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Adj Close
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Risk Free Rate
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(ii) Obtain beta by regressing the company's excess returns against those of S&P 500 (Include a table of your results).
(iii) Discuss your regression results and its implications on investing in the index as opposed to the company. Your discussion should include the effect of the financial crisis (November 2007 - May 2009).
(iv) Create a graph of the Security Market line (SML);
(v) What does the SML graph tell you about the mean-beta relationship?
B. Fama and French 3-Factor Model:
Using all the previous data downloaded from Professor Kenneth French's website, perform the following steps:
a)
(i) Merge the previously calculated company excess returns with the Fama and French factors (You may wish to recreate the table below). Then regress the company's excess returns against the Fama and French factors.
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Date
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Company - Risk Free Rate
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Mkt-RF
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SMB
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HML
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RF
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(ii) Discuss your regression results and compare it to the CAPM results.
b) Using relevant literature, critically analyze the validity of CAPM and the Fama and French three factor model. Your discussion should include underlying assumptions, implications, and practical applications.
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