The Application of the Fama and French Factor Model for the Sri Lankan Stock Market

Abstract

The explanation of the movement of stock returns is a complex task and has been the subject of research with the objective of identifying potential investment opportunities. A single-factor model, where the stock returns are driven by one variable, is often used to identify the mispricing of stocks. One such single-factor model is the Capital Asset Pricing Model (CAPM) which uses the market beta (the sensitivity of an asset against the movement of the market) as the explanatory variable to model stock return. However a single factor alone is not sufficient to model the dynamics of the market. Often multiple factors are used for modelling purposes such as size, value each of which captures a different characteristic of the market thereby improving the fit of the model. Fama & French (1992) identified that the CAPM model does not sufficiently explain the average stock returns in the US market. Thus the CAPM was further improved with the introduction of two additional factors. This three-factor model of Fama and French (1993) indicates that expected returns can be explained by excess market returns, a size-factor and a book-to-market equity factor.