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    O I to 4G+ it 21:10 43% Ψ§Ω„ You CHEN TWO Todayn 16:07ago possibly explain all the variation in expected returns. It says that you only need one measure of risk, and that's the sensitivity to the market return." Having shown CAPM doesn't work, Fama and French went on to examine multi-factor models that allow many different sources of risk to impact expected returns. "If you want to explain average stock returns, we found you need three measures of risk," he says. "Those measures are sensitivity to the market return and two other measures: a measure to distinguish the risks in small stocks versus big stocks, and a measure to distinguish the risks in value stocks versus growth stocks." In papers published since then, Fama and French have tested that theory to determine whether it holds up. "We tested it first on U.S. stocks and found that the theory holds up pretty well in domestic portfolios," he explained. "In this report, we looked at international stocks as well. We looked at 13 countries, the U.S. among them, and found that again the theory worked well. The data base allowed us to look only at big stocks, so we couldn't test the size measure. But the measure of value versus growth holds up." Fama and French discovered that what was needed to explain average returns in this set of large international stocks was a market risk factor and a value-growth risk factor. The market risk factor is the return on an international market portfolio of stocks, and the value-growth factor is the difference between the return on an international portfolio of high book-to- market stocks and the return on an international portfolio of low book-to-market stocks. The implications for investors are that, first, the CAPM gives "too simplistic a view of the world," says Fama. "There are at least two additional dimensions of risk that get rewarded in average returns. And that's true in both domestic and international portfolios of stocks." A second implication for investors is that value stocks have higher returns than growth stocks in markets around the world. Looking at book-to-market equity, Fama and French found that value stocks outperformed growth stocks in 12 of 13 developed countries from 1975 to 1995, and that the difference between average returns on global portfolios of high and low book-to-market stocks was 7.6 percent per year. Furthermore, when earnings-to- price, cash flow-to-price and dividend-to-price were examined, the value premium continued to be evident. O I to 4G+ it Full 43% 21:10 You CHEN TWO Todayn 16:07ago Module Assessment Components In the following pages, further details of each assessment component are presented along with expectations in relation to prior preparation and completion. 1. Continuous Assessment: Individual Assignment (40%) PART A Eugene Fama from the University of Chicago and Kenneth R. French from the Yale School of Management examined the validity of the Capital Asset Pricing Model (CAPM) in a study that was published in 1992. The CAPM is the most recognized model to explain stock price returns and forms the foundation of Modern Portfolio Theory. Their extensive study showed that, at minimum, the CAPM was not a complete explanation of the factors explaining asset pricing. Their findings also have some implications for investment performance of growth versus value stocks. A summary of their key findings can be found in Rethinking Stock Returns below. After reading this summary, answer the following questions: 1) How did the researchers in the article "Rethinking Stock Returns" define value versus growth stocks? What relevance did their findings have on investing? 2) What factors did Fama and French examine that may explain stock returns? 3) The CAPM is built on a single measure of risk that explains asset returns. What measures of risk did Fama and French conclude were necessary to explain stock returns? 4) Describe the CAPM model and the Fama and French model and the implications of these models for investors. the 5) Finally download an academic paper of your choice from the last five years posted on Financial Economics network of the SSRN website (http://www.ssrn.com/en/index.cfm/fen/). The academic paper must use the Fama- French model in its analysis. Provide a 1000 word summary of the objective of this academic paper of your choice and the reasons why the Fama-French model was used in the paper. O I to 21:10 43% Ψ§Ω„ 4G + % You CHEN TWO Todayn 16:07ago Eugene F. Fama is the Robert R. McCormick Distinguished Service Professor of Finance at the University of Chicago Graduate School of Business. PART B A pension fund manager is considering three mutual funds. The first is a stock fund, the second is a corporate bond fund, and the third is a T-bill money market fund that yields a rate of 5.5%. The probability distributions of the risky funds are: Expected Return Standard Deviation 15% Stock fund (s) Bond fund (8) 32% 23 9 The correlation between the fund returns is 0.15 Required: (a) Draw the investment opportunity set of the two risky funds. Use investment proportions for the stock fund of 0% to 100% in increments of 10%. What expected return and standard deviation does your graph show for the minimum-variance portfolio? (b) What does your graph show for the expected return and standard deviation of the optimal risky portfolio? (c) Suppose your portfolio must yield an expected return of 12% and be efficient. (i) what is the standard deviation of your portfolio? (ii) What is the proportion invested in the T-bill fund and each of the two risky funds?
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    PART A
    Question No: 01
    Growth Stock and Value Stock: By growth stock the researcher mean to stock with high
    P/E and P/B ratio, and low dividend payout ratio. The investors have high growth expectation
    (relative to overall market) regarding these stocks. By value stock the researcher mean to stock
    with low P/E and P/B ratio, and high dividend payout ratio. The investors have low growth
    expectation (relative to overall market) regarding these stocks.
    Relevance of Findings on the Investment: Investors who have preference for income
    through value appreciation will like to make investment in growth stock. Investors who have
    preference for constant income (through dividend) will like to make investment in growth stock.
    Also, investors who have high growth expectation will like to make investment in growth stocks.
    On the other hand, investors seek undervalued stocks in the market will like to make investment
    in value stocks.
    Question No: 02
    Factors Examined by Fama and French that Explain the Stock’s Return: According to
    Fama & French model, there are three factors that explain the stock return in market. These
    include stock beta, size effect, and value effect.
    Question No: 03
    Measures of Risk Concluded by Fama and French in Explaining the Stock Return: The
    capital assets pricing model (CAPM) only considers market risk (responsiveness of stock’s
    volatility to market volatility) to explain the stock return. But the Fama-French model has
    expanded CAPM by considering other risk factors to explain the stock return accurately. Other

    risk factors considered in Fama-French model include size risk (incremental risk in portfolio
    with small cap stocks), and value risk (incremental risk in portfolio with value stocks).
    Question No: 04
    CAPM Model: The capital assets pricing model (CAPM) explains the asset or security
    return in consideration of systematic risk. Under this model, systematic risk (a measure of
    responsiveness of the asset or security return to overall market return) is the only single factor of
    asset or security return. The asset or security return is determined by adding the risk premium
    (additional market return over risk free rate) with the risk free rate. Risk premium is the
    compensation for systematic risk of asset or security.
    Required Rate of Return (K) = Risk Free Rate + (Beta * Risk Premium)
    Fama- French Model: CAPM is the brainchild of Fama-French model. Fama-French
    model adds additional two risk factors – size risk and value risk besides systematic risk factor...


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