Article Critique Sample Essay

Introduction:“The Value Premium and the CAPM” paper.

written by Eugene Fama and Kenneth French was published in the Journal of Finance in October 2006. Eugene Fama is an American economic expert. known for his work on portfolio theory and plus pricing and is working as a Professor of Finance at the Chicago University ; while Kenneth French is a research associate at the United States’ National Bureau of Economic Research and Professor of Finance at Tuck School of Business.

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Goals:The paper has three chief ends which it attempts to research ; First. to supply a simple image of how value premiums vary with house size. Second. to explicate if and when CAPM market ?’s explain ascertained value premiums and 3rd. to analyze whether in general. fluctuations in ? across stocks is related to mean returns in the manner predicted by the CAPM.
Literature Reappraisal:Other authors’ old surveies related to value premium and the CAPM have revealed that: a ) Tim Loughran ( “Book-to-market across house size. exchange and seasonality” .

Journal of Finance and Quantitative Analysis. 1997 ) : Contends that value premium is limited to little stocks. B ) Andrew Ang & A ; Joseph Chen ( “The CAPM over the long tally: 1926-2001” . Working Paper.

Columbia University. 2005 ) : Contend that CAPM can explicate U. S. value premiums. degree Celsius ) Eugene Fama & A ; Kenneth French ( “The cross subdivision of expected stock returns” . Journal of Finance. 1992 ) : Contend that there is a value premium in U. S.

stock returns for the station 1963 period. vitamin D ) Eugene Fama & A ; Kenneth French ( “Common hazard factors in the returns on stocks and bonds” . Journal of Financial Economics. 1993 ) : Contend that the post-1963 value premium is left unexplained by the Capital Asset Pricing Model.
Findingss:The findings of Fama and French in this paper suggest that: a ) There is a value premium in U. S. and international stock returns for the station 1963 period and this value premium is similar for large stocks every bit good as for little stocks. B ) CAPM can explicate the value premiums in the mean returns of 1926 to 1963.

but it is non able to explicate the ascertained station 1963 value premiums. degree Celsius ) It is the stock size. the Book-to-Market value or other hazards related to them and non ? that are rewarded in mean returns. Process & A ; Methodology:
The term “value premium” refers to the greater risk-adjusted return of value stocks over the growing stocks. The writers consider as value stocks those holding a high Book-to-Market ratio or high Earnings-to-Price ratio while as growing stocks those holding a low Book-to-Market ratio or low Earnings-to-Price ratio.

Both Time-Series and Cross Sectional Data were used in the analysisThe Book Value of Equity is derived by deducting liabilities and adding deferred revenue enhancements from entire assets while market value of equity is derived by multiplying the monetary value of a portion of stock by the figure of portions outstanding.Initially. the article attempts to supply a simple image on how the value premium varies with house size. To turn out the non-existence of a relationship between the value premium and the house size. Fama and French created 6 portfolios of U. S. stocks by categorising them based on their size and Book-to-Market ratio. The six portfolios of stocks created were: SV ( Small and Value Stocks ) .

SG ( Small and Growth Stocks ) . SN ( Small and Normal Stocks ) . BV ( Big and Value Stocks ) . BG ( Big and Growth Stocks ) and BN ( Big and Normal Stocks ) .Firms holding a market capitalisation below the NYSE median were considered as little stocks while those holding a market capitalisation above NYSE median were considered as large stocks. On the other side. houses holding a B/M ratio belonging to the bottom 30 % of NYSE. AMEX and NASDAQ B/M ratios were considered as growing stocks.

those belonging to the in-between 40 % were considered as Neutral and those belonging to the top 30 % were considered as Value Stocks.After specifying the six portfolios of stocks. Fama and French identified the size factor by mensurating the mean monthly return of the three little stocks ( SV+SN+SG ) /3 and subtracted it from the mean monthly return of the three big stocks ( BV+BN+BG ) /3. The consequences suggested that there is a negative relationship between value premium and a firm’s size significance that little firm’s had a higher value premium than big houses. However. when Fama and French applied the same method but classified Value & A ; Growth Stocks based on E/P ratio and non on B/M ratio they found a strong value premium on the largest stocks and small relation between the value premium and the house size.The same attack was used to place value premiums in the International Stocks every bit good. Fama & A ; Gallic analyzed the stocks of 14 major markets outside U.

S. and concluded that international returns show strong value premiums and this value premium is as big among the biggest stocks as among smaller stocks. After analysing the relationship between value premium and firm’s size for the U. S. stocks every bit good as for International stocks Fama and Gallic suggest that the weak relation between B/M and mean returns for the large U. S. stocks may be random and due to the little figure of stocks under the BV ( Big & A ; Value stocks ) class.Second.

Fama and French attempted to place if and when CAPM market ?s explain the ascertained value premiums. After placing the ?s for the period 1926-2004 they concluded that for the pre 1926 period where value stocks had higher ?s than growing stocks. CAPM captured value premium near absolutely while for the station 1963 period where value stocks had lower ?s than growing stock CAPM failed to foretell the ascertained consequences. Third.

Harmonizing to the Capital Asset Pricing Model theory. all fluctuations in ?s across stocks are compensated in the same manner in expected returns. However. when Fama and French formed their portfolios based on size. B/M and ?s they found that fluctuations in ?s that came as a consequence of fluctuations in size or B/M were compensated in expected returns while fluctuations in ?s unrelated to either size or B/M were left empty-handed.Finally.

based on the findings of Fama and French. we can reason that CAPM has fatal mistakes for the period 1926-2004. Size. B/M and other hazards related to them are of import in expected returns whether or non they relate to ?s in the manner predicted by CAPM and besides it is of import to stress that ?s have small or no independent function.MentionsFama.

F. E. . French. R. K. ( 2006 ) .

The Value Premium and the CAPM. The Journal of Finance. 61. 2163-2185.


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