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1 Part A Question 1How are the pricing factors computed and what do they represent? (hint: read the Fama and French (1996) paper – its on iLearn). Provide graphs and descriptive statistics for the SMALL_HiBM and BIG_LoBM portfolios and comment on their main characteristics. (5 marks) There are three main pricing factors these include the market risk premium, high minus low and small minus big. There are specific methods of computing each of these three pricing factors. Market risk premiumMarket risk premium comprises of the variance between the predictable return and the risk-free rate on the market portfolio. This market risk premium is the same as the incline of the security market line. There are three major market concepts to consider in computing market risk premium. These include required market risk premium, expected market risk premium and the historical market risk premium. Calculating this risk premium involves: finding the difference between the expected market premium and risk-free rate.Market risk premium =Expected market return-Risk free rate. Therefore, this price factor model is used by investors to measure their possibility that the investments will yield adequate returns to the investors. The presence of risk factor is one of the essential elements of a market that determines the rate of performance. A risk-free investment does not demonstrate a high level of return hence it does not become significant to the operationsof the firms.
2he MRP equation is expressed as follows:whereE[Ri] = the expected return on asset i,Rf= the risk-free rate,E[Rm] = the expected return on the market portfolio,bi= the Beta on asset i, andE[Rm] - Rf= the market risk premium.(E[Rm] - Rf) (market risk premium)
3High minus Low High minus Low is also termed as value premium. This strategy is always based on the book value, and it has it states that a higher book value in the market stock are termed as a value stock,while the lower book value of the market stock is termed as a growth stock. Therefore value stock has a tendency to give higher returns than the growth stock. Growth stock, which is associated with growing firms, may show an increased rates, but the actual performance is still minimal as compared to the value stock Calculation of high minus low therefore involve determining both the market value and the bookvalue of the stock Market value = number id outstanding shares * current market price in the stock = N * CMPr - Rf= [ B3* (Km- Rf)] + [ Bs* SMB] + [ Bv* HML] + [A]Here,r = Portfolio’s return rate,Rf = Risk-free return rate,B3 = Three factor beta,Km = Returns of the market,Bs = ‘0’ to ’1’, based on the portfolio. ‘1’ for pure small cap portfolio and Bv = ‘0’ to ’1’, based on the portfolio. ‘1’ for value stocks, ‘0’ for growth stocks.
4Book value is determined by looking at the historical accounting and cost of the company. Use the book value and the market value to find the HML. The ratio will determine whether a stock isa value stock or a growth stock.Small minus bigThis model focuses on the speed of returns between small firms and the large-sized firms, and it is based on the capitalization of the company's market. The principle behind this model is that there is a tendency of small effect in small firms to outperform the same effects in the big firms. Computation of small minus big involves:SMB= 1/3(small value small neutral +small growth) - 1/3(big value+ big neutral +big growth)
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