A RE-EXAMINATION OF FACTORS AFFECTING

RETURNS IN INDIAN STOCK MARKET

Rahul Kumar 1
Dr. Chandra Prakash Gupta2

1
The author is a member of The Institute of Chartered Accountants of India and a Research Scholar,
Management Development Institute, Gurgaon (India). He can be reached at fpm05rahul_k@mdi.ac.in.
Mobile +919911007220
2
The author is Professor in Finance, Management Development Institute, Gurgaon (India). He can be
reached at guptacp@mdi.ac.in. Mobile +919818041308
Abstract

The paper evaluates the return generating process for the Indian stock market implied by

general multi-factor model and the Fama-French three-factors model in specific. It tests

systematically and robustly the relevance of Fama-French three-factor model in

explaining the cross sectional differences in returns in Indian using a large sample data

pooled from wide range of companies and periods. The empirical results show that the

Indian equity market exhibits a strong size effect and value effect which are consistent

with the findings of Fama and French (1996) for US portfolios and Sehgal (2003) for

Indian stocks. Thus, it provides an evidence of the pervasiveness of the Fama-French

three-factor model in explaining the cross sectional differences of stock returns. This

study may provide a strong support for a broader and generalized asset pricing model in

which there are multiple risk factors.

Key words: Multi-Factor Model; Asset Pricing; Size effect; Value effect.

II
Introduction

The primary implication of the Single Index Model3 developed by Sharpe (1964) is that

the portfolio risk can be divided into two parts, namely, diversifiable (unsystematic), and

non-diversifiable (systematic). Unsystematic risk is the component of the portfolio risk

that can be eliminated by increasing the portfolio size, the reason being that risks that are

specific to an individual security can be eliminated by constructing a well-diversified

portfolio. Systematic risk is associated with overall movements in the general market or

economy and therefore is often referred to as the market risk. The market risk is the

component of the total risk that cannot be eliminated through portfolio diversification

(Elton and Gruber, 1996). Based on the Single Index Model, Sharpe (1964), Lintner

(1965) and Mossin (1966) independently developed what has come to be known as the

Capital Asset Pricing Model (CAPM).The Capital Asset Pricing Model (CAPM) relates

the expected rate of return of an individual security to a measure of its systematic risk

(Galagedera, 2004). The oldest complete model of asset pricing, the model explains the

differences in riskiness between assets. Miller (1999) stated that CAPM not only

expressed new and powerful insight into the nature of risk but also through its empirical

investigation contributed to the development of finance and to major innovation in the

field of econometrics. The CAPM is an ex-ante equilibrium model based on expectations

and a string of assumptions (Malin & Veeraghavan, 2004). The CAPM model states that

(a) expected returns on security is a positive linear function of its market β (the slope in

the regression of a security’s return on the market’s return), and (b) the market β

suffices to describe the cross section of expected return.

3
Details of the Single Index Model is given in Appendix - I

1
Following the publication of Single Index Model and CAPM, there were many empirical

studies that tested whether the model adequately describes the way stock market prices

behave in practice. Many empirical researchers have found that there are influences

beyond the market that cause stocks prices to move together (Elton & Gruber, 1996) and

this laid to the development of multi-index4 (multifactor5) models. Specifically, these

studies have found through their empirical researches that single factor (market) is not

sufficient in explaining security returns, as postulated by single index model and CAPM.

Further, these studies found that the company variables, that do not find a place in one

factor asset pricing framework of CAPM, tend to empirically exhibit a relationship with

stock returns. Prominent amongst these company characteristics are Firm size (measured

in terms of market capitalization) [(Banz, 1981), (Cook and Roseff, 1982)], earning- yield

(E/P Ratio) [(Ball, 1978), (Basu, 1983)], Leverage (Bhandari, 1988), Cash flow to price

(C/P ratio) [(Hawawini,1991), (Chan, Hamao, and Lakonishok, 1991)] and the firm’s

book-to-market equity (BE/ME) ratio (Chan, Hamao, and Lakonishok, 1991). These

company characteristics were found to provide a better explanation than market factor

alone for the cross-section of average stock returns. These evidences suggest that

multifactor models should be considered in research applications that require estimates of

expected returns (Fama, 1996).

It is now well accepted that multi-factor model is a natural representation of the real

world, but a central empirical issue is which factors best account for differences in the
4
For the purpose of this study, the terms ‘multi-index’ and ‘multifactor’ are used synonymously, unless
stated otherwise.
5
Multifactor models are an attempt to capture some of the non market influences that cause securities to
move together (Elton & Gruber, 1996).

2
returns and thus, finally providing the systematic risks in the market for a multi-factor

asset pricing model. In an empirical attempt to operationalise multifactor model, Fama

and French developed three-factor model. Using a multifactor approach, they, in their

landmark paper in 1992, empirically examined the joint role of market beta, firm’s size,

firm’s book-to-market equity (BE/ME) ratio, earning yield (E/P ratio) and leverage in the

cross-section of average stock returns. They found that (a) the excess market return has

some information about average returns; and (b) the combination of size (market

capitalization) and book-to-market (BE/ME) absorbs the role of leverage and earning

yield (E/P) in average stock returns. Based on their empirical findings in Fama and

French (1992), Fama and French (1993) propounded a three-factor asset pricing model,

comprising of the market factor and two mimicking portfolios that proxy for common

factors in returns relating to size and book to market equity (often called a “value”). They

showed that their three-factor model captures much of the variations in the cross-section

of average stock returns in a portfolio, which is missed by Sharpe’s Single Index Model.

The conclusions reached by the Fama and French (1993) could be consistent with a

multifactor version of Merton’s (1973) intertemporal capital asset pricing model

(ICAPM) or the arbitrage pricing model (APT) of Ross (1976), in suggesting that the

higher average returns on value stocks are compensation for risk missed by the CAPM.

The contribution of Fama-French (1996), particularly relating to the interpretation of the

results, ignited a flurry of responses from the academy. The first wave of responses was

based on result of DeBondt and Thaler (1987). Based on the empirical evidences of

overreaction hypothesis of DeBondt and Thaler (1987), Lakonishok, Shleifer, and

3
Vishny (1994) and Haugen (1995), suggests that the high returns associated with value

stocks are generated by investors who incorrectly extrapolate the past earnings growth

rates of firms. As a result, the market tends to undervalue low BE/ME stocks and

overvalue low size stocks.

A second area of controversy relates to the controversial findings of Daniel and Titman

(1997), suggesting that the return premia on small capitalization and value stocks do not

arise because of the co-movement of these stocks with pervasive factors. They argued

that it is characteristics of the portfolios constructed by sorting rather than the covariance

structure of returns that appear to explain the cross-section variation in stock returns.

Moreover, they further claim that the value premia in the three-factor model are

determined by value characteristics, not by underlying risk characteristics.

In replying to the critique of the Fama and French mulitfactor model, Davis, Fama and

French (2000) extend data back to 1926 (a 68-year sample period) and expand the sample

coverage to all NYSE industrial firms. The results provide no evidence of a sample-

specific explanation for the value premium, with the value premium in pre-1963 returns

close to that observed for the subsequent period in earlier work. These results led Davis et

al (2000) to conclude that the model of Fama and French (1996) explains the value

premium better than the characteristic based model of Daniel and Titman (1997).

Moreover, Davis et al suggest that the evidence in favor of the characteristic model,

provided by Daniel and Titman (1997), appears to be a feature of the sample period.

Davis et al (2000) note that “the acid test of a multifactor model is whether it explains

differences in returns.” and not a particular type of covariance structure.

4
Presently there is considerable evidence from other world markets in support of the three-

factor model. [Chan, Hano, and Lakonishok (1991), Capasul, Rowley and Sharpe (1993),

Fama and French (1998), Chui and Wei (1998)]. However much of the empirical support

is limited to developed capital markets. Kothari, Shanken and Sloan (1995) asserted that

any robust multi-factor model must be tested to work under a variety of conditions and

not for a limited set of portfolios. Hence, there is a need for more sample tests, especially

relating to emerging markets. It is commonly observed that emerging market returns have

unusual features6 [Harvey C (1995)]. Hence they pose a greater challenge to the universal

applicability of rational asset pricing theory. Indian capital market is grossly under-

researched in the area of CAPM and factors model (Manjunatha and Mallikakarjunappa,

2006).

The result of empirical studies in Indian context (Vaidyanathan and Chava, 1997;

Marisetty and Vedpurishwar 2002; Mohanty, 1998, 2002; Sehgal, 2003; Connor and

Sehgal, 2003) supports the Fama and French multi-factor model. However, a recent study

carried out by Manjunatha and Mallikakarjunappa (2006) reveal confounding relationship

among factors viz., market, size, and book-to-market (BE/ME) ratio and portfolio return

(dependent variable). Their study is based on daily data of 66 companies and is

susceptible to suffer from selection bias. Further, various empirical researches suggest

that the fat tails7 are more commonly observable in daily data than monthly data.
6
Emerging markets differ from developed markets as they are expected to exhibit lower level of market
efficiency, a less evolved institutional and regulatory framework, and less mature investor behavior. Their
economic parameters are relatively unstable, and hence less predictable, and their stock markets are fairly
volatile.
7
A distribution is said to be a ‘fat-tailed’ or ‘heavy tailed distribution’ if the tails of a non-normal
distribution are heavier than the normal distribution. Fat-tailed distributions are also leptokurtic

5
(Agrawal, Rao, and Hiraki (1989) Hence, taking daily data for the regression analysis

may lead to spurious results. The diverse findings in Indian context demands systematic

investigation of the effectiveness of the model by taking a large sample of data pooled

from wide range of companies and periods. And, it is this demand that provides the

necessary motivation for the present study. Therefore, the objective of the current study is

to empirically examine the effectiveness of three-factor model, by testing its validity in

different time periods and on different data sets, in explaining the cross section of stock

returns in Indian market.

The remainder of the study proceeds as follows: Section 2 outlines the objective of the

current study. Section 3 describes the underlying data, date source and data definition.

Section 4 describes the methodology followed for examining factors affecting returns.

Section 5 presents and discusses empirical results and finally, the article ends with

conclusion and directions for future research.

Objectives of the study

The confounding empirical results in the literature on Fama and French three-factor

model demands systematic investigation of the effectiveness of the model by taking a

large sample of data pooled from wide range of companies and periods, especially in

emerging economies like India. As discussed earlier, the empirical results related to

multi-factor models in India are showing diverse results so as to reach at some

conclusion. Therefore, there is a need to re-examine the whole issues related to the
distribution.

6
effectiveness of three-factor model in India in explaining differences in returns on various

stocks. Consequently, the current study is aimed at examining empirically the

effectiveness of three-factor model – that is, by testing its validity in different time

periods and on different data sets, in explaining the cross section of stock returns in

Indian market. With this objective the study specifically examines the following

questions:-

• Is there a significant size effect in Indian stock returns?

• Is there a significant value (BE/ME) effect in Indian stock returns?

• Is the Fama-French three-factor model a better descriptor of return generating

process in Indian context as compared to Single Factor Model?

Data source and data definition

The data comprises of the month end adjusted share price for companies from August

1990 to March 2006. The sample companies form part of S&P CNX 5008, a broad based

stock market index that gives representation to companies of varying level of size and

trading activity. The sample companies account for a major portion of the market

capitalization and average trading volume in India, and hence are presumed to be fairly

representative of market performance. Moreover, bulk of the out of sample companies are

either very thinly traded or do not provide a long and continuous track record of financial

and accounting information. Their inclusion would have posed a serious estimation

problem.

8
Earlier known as CRISIL 500 Equity Index

7
The adjusted share price data has been obtained from CMIE database “Prowess”, the

leading financial database in India. The share price series has been used to construct

monthly return series. The National Index of the Bombay Stock Exchange (BSE, India)

has been used as a surrogate for market index. The BSE National Index is a broad based

and value weighted stock market proxy, constructed on the lines of Standard and Poor,

USA.

Implicit yield on 91 Treasury bill (T- Bills) have been used as proxy for risk free return.

The data source is Reserve Bank of India Bulletin. Since the auction of 91 days Treasury

bill was introduced in India from January 1, 1993, for the period August, 1990 to

December, 1992 the monthly running yield on Government of India securities are taken

as proxy for risk free return. The data source is Report on Currency and Finance, an

annual publication of the Reserve Bank of India.

The necessary accounting information have been obtained for the sample companies from

1990 to 2006 for March end each year, which is the financial closing month in India and

is followed by the sample companies under study. The data source is CMIE Prowess,

which is extensively used by academic researchers as well as practitioners in India.

Data Definition

i. Size: Market equity (ME) stands as the proxy for the size. ME is also termed as

Market Capitalization which is market price per share times number of shares

outstanding. Market capitalization is calculated in the beginning of July of each year

8
 t. We have assumed a time lag of one quarter (three months) from the end of the

financial year for the release of financial information to the public by companies.

ii. BE/ME: BE/ME is the ratio of Book value per share of equity to market value per

share of equity. BE/ME is also termed as “value”. BE/ME has been calculated as

book value per share in March end of year t, divided by the market value per share in

beginning July of year t.

Table- I presents the summary statistics of the sample data for the annual period of 1990

to 2006. Column (2) of table (1) represents the number of observations in each year

available for the study. Column (3) to (6) shows the summary statistics of Size (measured

in terms of market capitalization of firms). Column (6) to (8) represents the summary

statistics of BE/ME ratio of firms.

Table I : Summary Statistics of the Sample Data for the annual period of 1990 TO 2006.
Year No. of Obs. Size (Rs. In Crores) Book to Market Ratio
Median Mean Std. Dev Median Mean Std. Dev
(1) (2) (3) (4) (5) (6) (7) (8)
1990 190 188.38 59.62 399.23 15.65 1.74 100.16
1991 205 246.81 81.38 528.48 13.73 1.22 105.86
1992 232 416.16 142.95 986.33 5.75 0.35 60.53
1993 259 480.27 125.11 1048.45 5.83 0.94 38.91
1994 307 975.73 283.20 2325.32 2.60 0.58 8.95
1995 339 726.28 190.51 1663.70 3.29 0.70 23.09
1996 365 940.46 150.56 2916.24 4.86 1.13 32.83
1997 375 1145.51 138.00 4057.26 5.40 1.97 12.72
1998 387 859.39 115.37 2963.14 6.71 2.12 17.27
1999 394 1173.31 180.05 4191.53 6.08 2.25 13.13
2000 408 1338.17 136.47 5216.42 4.92 1.85 11.46
2001 430 985.81 103.29 3971.57 7.21 2.61 16.38
2002 439 1105.37 155.18 3934.95 6.24 2.42 14.01
2003 449 1515.87 227.55 5189.35 5.34 2.06 11.34
2004 455 2258.32 372.36 7460.70 2.07 0.97 4.99
2005 471 3748.47 826.60 11038.45 1.04 0.60 1.74
2006 487 4826.81 1045.05 14535.88 0.54 0.39 0.50

9
Methodology for examining factor affecting returns

This study primarily adopts the methodology suggested in Fama and French (1993) to

capture the cross sectional variation in returns. For the purpose of this study, return at

time t, R(t), is defined as shown in equation (1).

 P (t ) 
R p (t ) =
 P (t −1) −1
 (1)
 

Where:-

R p (t ) : Return of portfolio p at time t

P (t) : Price of a security at the end of month t

P (t-1) : Price of a security at the end of month t-1

Figure I presents graphically the process followed for examining the factors affecting
returns in the Indian stock market.

10
Figure I: Graphical representation of the methodology for examining common factors affecting

returns

Now, we describe the procedure followed for examining factors affecting return

generating process:-

Create Size Portfolios

We focus on size portfolio and for the purpose in the beginning of July of each year t

from 1990 to 2006, on the basis of ME, all the sample stocks are sorted in descending

order on the basis of size. The sample is then divided into three groups based on the

11
breakpoints for the bottom 30% (Small), middle 40% (Central), and top 30% (Big). This

leads to creation of three size portfolios of stocks falling under each group viz. Small,

Central, and Big named as S, C, and B respectively.

Create Value portfolio

In the next stage, beginning July of each year t, on the basis of BE/ME we sorted the

sample stocks in descending order and created three value portfolios based on the

breakpoints for the bottom 30% (Low), middle 40% (Medium) and top 30% (High) of the

ranked values of BE/ME of sample companies. This leads to creation of three value

portfolios of stocks falling under each group viz. Low, Medium, and High named as L,

M, and H respectively.

The split of the sample stocks into different categories (3 ME groups and 3 BE/ME

groups) is arbitrary and Fama and French argued that there is no reason that the tests

should be sensitive to this choice.

Calculate size and value portfolio return

We then calculate returns on nine portfolios constructed from the intersection of three

sizes and three BE/ME groups named as S/L, S/M, S/H, C/L, C/M, C/H, B/L, B/M, and

B/H. S/L portfolio contains stocks of small ME and low BE/ME companies, while B/H

portfolio represents big ME companies with high BE/ME ratio. Monthly equally

12
weighted returns on the nine portfolios are calculated from July of year t to June of year

t+1, and the portfolios are reformed in July of year t+1. We calculate returns beginning in

July of year t to ensure that the book equity for year t is known to the investors by that

time for decision making purposes.

The nine size BE/ME portfolios have been consciously constructed to be equally

weighted as suggested by Lakonishok, Shliefer and Vishny (1994), since they contain

less estimation errors compared to the value weighted portfolios. Fama and French

(1996) documented that the three-factor model does a better job in explaining equally

weighted portfolios than value weighted portfolios.

Size and Value factors return

The Fama- French methodology involves use of three-factors for explaining returns. The

market factor (Rm – Rf) and other two factors relating to size (SMB) and BE/ME ratio

(HML). Given the market factor, we next construct the SMB and HML factors return. To

calculate SMB and HML returns, as explained earlier, companies are divided into nine

groups based on size and the BE/ME ratio. The intersections of the three sizes and three

BE/ME groups produce nine portfolios of stocks which are used to compute the SMB and

HML factor returns.

The SMB factor return is the average of return on three small size portfolio i.e. {(average

of (S/L, S/M, & S/H))} minus the average of return on three big size portfolios i.e.

13
{(average of (B/L, B/M, B/H))}. These returns are calculated for each month over the 12

months following portfolio formation. The process was repeated until the portfolios were

reconstructed. Similarly, the HML factor return is the average of return on three high

BE/ME portfolios i.e. {(average of (H/S, H/C, & H/B))} minus the average of return on

three low BE/ME portfolios i.e. {average of (L/S, L/C, & L/B))}. This way monthly

factor returns are calculated for the each month over the 12 months following portfolio

formation. The process was repeated until the portfolios were reconstructed. In the next

stage, we investigate the relationship between portfolio returns and explanatory variables

viz., market factor, size (ME), and value (BE/ME) factors.

Examination of explanatory factors of returns

We run time series regressions, to examine whether different risk factors, individually

and/or collectively, capture variations in returns. The time series regression equations to

examine the relationship between portfolio returns and overall market factor, size (ME),

and value (BE/ME) factors, separately and/or collectively are listed in equation (2) to (6)

as follows:-

a. Regression using only the market factor (RM – RF) as explanatory variable (the

Single Index Model). Symbolically,

R pt −R ft =αi +bi ( Rmt −R ft ) +et (2)

b. Regression using SMB and HML as explanatory factors. Symbolically,

R pt − R ft =αi + s i ( SMB t ) + hi ( HML t ) + et (3)

c. Regression using market and SMB as explanatory factors. Symbolically,

14
 R pt − R ft =αi + bi ( Rmt − R ft ) + s i ( SMB t ) + et (4)

d. Regression using market and SMB as explanatory factors. Symbolically,

R pt − R ft =αi + bi ( Rmt − R ft ) + hi ( HML t ) + et (5)

e. Regression using market, SMB and HML factors (the Fama French Model)

R pt − R ft = αi + bi ( Rmt − R ft ) + s i ( SMB t ) + hi ( HML t ) + et (6)

Where:

R pt is the monthly return of a certain portfolio (S/L, S/M, S/H, C/L, C/M,C/H, B/L,

B/M, B/H). R ft is the monthly risk free rate. Rmt is the monthly return on market. For

the purpose of this study, Bombay stock exchange (BSE, India) national index has been

used as a surrogate for market.

SMB (Small minus Big) represents the size factor. HML (High minus Low) represents

the BE/ME (value) factor. The loadings bi , si , and hi are the slopes in the time series

regression.

Thereafter, before making any final assertion about the risk factors in explaining returns,

we examined the significance of the intercept of the regression equation listed in equation

(2) to (6).

Data analysis and discussion

15
Table II shows the mean monthly returns over the risk free return (excess return) on the

Size & BE/ME sorted portfolios. The nine size BE/ME portfolios exhibit an excess return

ranging from -0.31% to 1.45% per month. The portfolio returns confirm the Fama (1993,

1995) evidence that there is a negative relation between size and return. Various theories

have been put forth to explain the size effect. One of the most frequently mentioned

explanations holds that small stocks contain some systematic risks that are not adequately

measured by empirical researchers. Small firms are small because the market uses a high

discount rate to capitalize its future cash flows, or because they have lost market values

due to poor past performance. They are more likely to have cash flow problems and less

likely to survive adverse economic conditions. Since these risks cannot be easily captured

by empirical models, small stocks tend to exhibit a higher risk-adjusted return. (See, for

example, Chan and Chen (1991), Fama and French (1996), Berk (1995), Vassalou and

Xing (2004), Berk, Green, and Naik (1999), Gomes, Kogan, and Zhang (2003)]. Chan

and Chen (1991) reported that the firm size proxy a distress effect in expected stock

returns. Other explanation for the size effect, dating back to Stoll and Whaley (1983), is

based on liquidity. Larger stocks are generally more liquid, and investors are willing to

compromise returns for higher liquidity. Therefore equilibrium returns of larger stocks

are lower. Another possible explanation of the size effect can be the transaction cost.

Since the large stocks attract lesser transaction costs such as search cost, monitoring cost

etc vis-à-vis that of small stocks, size premium for large stocks are negative.

Furthermore as shown in table II, the relation between BE/ME and return is positive.

Various researchers attempted to explain the value premium in stock returns. Chan and

16
Chen (1991) and Fama and French (1992) suggested that it is possible that the risk

captured by BE/ME is the relative distress factor. They postulate that the earning

prospects of the firms are associated with a risk factor in returns. Firms that the market

judges to have poor prospects signaled here by low stock price and high ratios of book to

market equity have higher expected returns (they are penalized with higher cost of

capital) than firms with high prospects.

Hence, the Indian equity market seems to exhibit a strong size effect and value effect.

This finding contrast with Fama and French (1995) findings where they show a strong

value effect and a conditional size effect for US data.

Table II : Mean monthly excess returns on the Size (ME)– Value (BE/ME) sorted
portfolios
Value (BE/ME)
Low Medium High
Size (ME)

Small 0.76% 0.85% 1.45%

Central -0.30% 0.07% 1.17%

Big -0.31% 0.03% 0.62%

Table III provides the summary statistics of risk premiums of the factors viz., market,

size, and value factors. The average value of RM - RF (average premium per unit of

market factor) is 0.64% per month. The annual excess return of about 7.71% is low from

the investors’ perspective compared to the risks posed by emerging market such as India

and the risk free rate of return available on investment in 91 days Treasury bill. The

average SMB factor return (the average premium for the size factor in returns) is about

17
0.90% per. The size premium is about 1.14 times the market premium. The average HML

factor return (the average premium for the value factor in return) is 1.03% per month.

Table III : Summary statistics of Market, Size, and Book to Market

Mean Standard
Deviation
RM-RF 0.0064 0.087
SMB 0.0090 0.047
HML 0.0103 0.033

Table IV provides the Pearson’s correlation coefficient between factor returns. The

correlation is significant between market, SMB, and HML suggesting some overlapping

amongst factors.

Table IV: Pearson’s Correlation Coeffecient between Market, SMB and HML Factors
Market SMB HML
Market 1 -.216(**) .145(*)
SMB -.358(**)
HML
** Correlation is significant at the 0.01 level (2-tailed).
* Correlation is significant at the 0.05 level (2-tailed).
In the subsequent sub-section, we report and discuss the empirical results of our time

series regressions.

The market factor as explanatory variable

Table V reports the result of the regression using market factor as explanatory variable of

the stock returns. The slope of the market factor (b) indicates that beta risk does not vary

significantly between smaller companies and companies with lower BE/ME ratio, and big

18
companies and companies with high BE/ME ratio. The empirical result is not consistent

with Fama and French (1993). Further, our result (see Table V) shows that the market

factor coefficient (b) is positive and highly significant in all nine portfolios. The t

statistics of all the beta (b) values are more than 7 implying statistical significance of beta

in explaining cross section of expected returns. The adjusted R2 value ranges from 0.20 to

0.62 for the sample portfolios. The adjusted R2 values are relatively lower for small size

stock portfolios (S/L, S/M, and S/H) showing the inability of single index model’s market

factor in explaining the size effects in return. The average of adjusted R2 is 40.63%. It

implies that market factor does explain a proportion of the common variation in stock

returns.

Table V : Excess Portfolio Returns Regressed on Excess Returns for the Market Factor
R pt −R ft =αi +bi ( Rmt −R ft ) +et
Portfolio b t(b) Adjusted R2
S/L 0.554 7.23 0.204
S/M 0.426 7.05 0.197
S/H 0.541 9.84 0.324
C/L 0.607 11.70 0.405
C/M 0.692 12.37 0.433
C/H 0.647 13.92 0.492
B/L 0.564 14.17 0.501
B/M 0.604 13.49 0.476
B/H 0.704 18.22 0.624

SMB and HML factors as explanatory variable:

Table VI shows the power of size and value factors in explaining portfolio returns. The

SMB slopes (s) are statistically significant at the 5% level for the small stock and central

19
stock portfolios (S/L, S/M, S/H and C/L, C/M, C/H). But for big size portfolios (B/L,

B/M, and B/H) slopes (s) are not statistically significant. The HML slopes (h) indicate

strong significance for low and high value stocks, but for the central value stock, it does

not indicate statistically significant effect. The average of the adjusted R2 is 13%

indicating that that in the absence of the market factor, the SMB and HML fail to capture

common variations in returns.

Table VI : Excess Portfolio Returns Regressed on Mimicking returns for Size (SMB) and
Value (HML) factors

R pt − R ft =αi + si ( SMB t ) + hi ( HML t ) + et

Portfolio s h t(s) t(h) Adjusted R2

S/L 1.063 -0.92 8.04 -4.91 0.399
S/M 0.881 0.09 7.50 0.55 0.230
S/H 0.933 0.582 8.10 3.56 0.243
C/L 0.313 -0.387 2.42 -2.12 0.06
C/M 0.362 0.151 2.48 0.73 0.201
C/H 0.341 0.208 2.67 1.15 0.025
B/L -0.097 -0.543 -0.89 -3.52 0.050
B/M -0.029 -0.063 -0.24 -0.36 -0.009
B/H 0.004 0.361 0.033 2.05 0.013

Market and SMB factors as explanatory variable:

Table VII shows that the coefficients of the market factor (b), and size factor (s) is

positive and highly significant in the case of all of the nine portfolios. While t statistics of

all the market slopes are more than 14 standard errors from 0, the size slopes are

statistically significant at the 5% level for small stock portfolios. The improved adjusted

R2 values for the small stock portfolios also confirm that the size factor in association

with market factors contributes noticeably towards the explanation of stock returns. The

20
average of the adjusted R2 is 58.37% which indicate that the market and SMB factors

capture a greater proportion of common variations in returns compared to one factor

single index model.

Table VII : Excess portfolio returns regressed on excess returns for the market factor
and mimicking returns for the size (SMB) factors

R pt − R ft =αi + bi ( Rmt − R ft ) + s i ( SMB t ) + et

Portfolio b s t(b) t(s) Adjusted R2
S/L 0.7398 1.591 14.91 17.34 0.683
S/M 0.553 1.078 11.96 12.62 0.553
S/H 0.663 1.051 16.88 14.46 0.671
C/L 0.688 0.686 14.85 8.01 0.549
C/M 0.765 0.629 14.69 6.54 0.532
C/H 0.715 0.574 16.87 7.33 0.600
B/L 0.596 0.278 15.13 3.82 0.533
B/M 0.632 0.238 14.02 2.87 0.495
B/H 0.728 0.204 18.718 2.83 0.637

Market and HML factors as explanatory variable:

Table VIII presents the impact of market factor and value factor in explaining returns.

We observe from Table VIII that market slopes are statistically significant at 5% level in

all cases. The value factor coefficient (h) is negative for all portfolios except (B/H)

portfolio, and statistically significant for the (S/L), (S/M), (C/L), (C/M), (B/L), and (B/M)

portfolios. The value factor coefficient (h) increases monotonically for the low value

portfolio to high value portfolio. The result suggests pervasiveness of value effect in

return. The average of the adjusted R2 is 46.87% and show a marginal improvement in

explanation of the cross sectional differences in returns as compared to the regression

model using market factor alone (table- V)

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 Table VIII : Excess portfolio returns regressed on excess returns for the market factor
and mimicking returns for the Book to market equity (HML) factors
R pt − R ft =αi + bi ( Rmt − R ft ) + hi ( HML t ) + et
Portfolio b h t(b) t(h) Adjusted R2
S/L 0.649 -1.706 10.39 -10.42 0.485
S/M 0.456 -0.529 7.65 -3.39 0.237
S/H 0.546 -0.100 9.817 -0.69 0.323
C/L 0.652 -0.796 13.59 -6.336 0.504
C/M 0.709 -0.304 12.637 -2.068 0.442
C/H 0.659 -0.217 14.102 -1.774 0.497
B/L 0.604 -0.724 17.182 -7.866 0.618
B/M 0.619 -0.285 13.864 -2.438 0.489
B/H 0.699 0.091 17.88 0.892 0.624

a. Market, SMB and HML factors as explanatory variable

Table IX shows the regression results using all the three-factors viz. market, size, and

value to explain the portfolio returns. We observe from Table IX that the market slope (b)

and SMB slope (s) are positive and statistically significant in all the cases. The SMB

slope (s) is decreasing from small to big size portfolio. The HML slope (h) is statistically

significant except in the case of S/M, C/M and C/H stock portfolios. The HML slope (h)

is monotonically increasing from low to high value stocks. The mean adjusted R2 of the

regression model is 61.2% indicating that the three-factor model provides the best

description of portfolio returns.

Table IX : Excess portfolio returns regressed on excess returns for the market
factor and mimicking returns for the size (SMB) and Book to market equity
(HML) factors

R pt − R ft = αi + bi ( Rmt − R ft ) + s i ( SMB t ) + hi ( HML t ) + et

Portfolio b s H t(b) t(s) t(h) Adjusted R2
S/L 0.76 1.330 -1.077 18.66 16.46 -9.544 0.782
9 8 7

22
 S/M 0.55 1.073 -0.022 11.91 11.78 -0.174 0.551
3 2 6
S/H 0.65 1.159 0.447 17.24 15.67 4.329 0.698
1 9 7
C/L 0.70 0.557 -0.533 15.80 6.398 -4.375 0.587
2 5
C/M 0.76 0.628 -0.007 14.62 6.119 -0.049 0.529
5 4
C/H 0.71 0.588 0.060 16.75 7.058 0.521 0.597
3 5
B/L 0.61 0.116 -0.669 17.28 1.668 -6.872 0.622
4 2
B/M 0.63 0.192 -0.195 14.15 2.175 -1.580 0.498
7 9
B/H 0.72 0.255 0.211 18.65 3.364 1.999 0.643
2 5

Testing of significance of intercept

The regression results in Table IX suggest that the market, SMB and HML proxy for

common risk factors in returns. We next verify if the proxy risk factors suffice to explain

the returns on portfolio. If the explanatory factors are suitable and sufficient proxies for

underlying common risk factors, the intercept of the time series regression of excess

returns on the mimicking portfolios should not be significantly different from 0. Table X

lays out the intercept results for regression in Table V to Table IX.

While the intercepts of regressions (b) (c)and (d), relating to Table V to VII, are

important, the intercept of the regression (a) and (f) are of great interest as they pertain to

the one factor single index model and three-factor model respectively. Using the single

factor model, the intercept values are statistically significant for S/H portfolio at 5%

level. The sample intercepts however sober down and none of them are statistically

23
significant in the three-factor model framework. These intercept term confirm that the

three-factor model does capture most of the variations in stock returns, that is missed by

single factor model.

Table X: Intercepts for Excess returns on nine portfolios formed on Size and BE/ME
(a) R pt −R ft =αi +bi ( Rmt −R ft ) +et
Portfolio a t (a)
S/L 0.004 0.605
S/M 0.005 1.094
S/H 0.0109 2.286
C/L -0.006 -1.522
C/M -0.003 -0.757
C/H 0.007 1.856
B/L -0.006 -1.944
B/M -0.003 -0.919
B/H 0.001 0.500

(b) R pt −R ft =αi + s i ( SMB t ) + hi ( HML t ) + et

Portfolio a t(a)
S/L 0.007 1.166
S/M -0.0004 -0.073
S/H -1.93E-5 -0.003
C/L -0.001 -0.298
C/M -0.004 -0.583
C/H 0.006 1.050
B/L 0.003 0.636
B/M 0.001 0.202
B/H 0.002 0.410

24
 ( c) R pt − R ft =αi + bi ( Rmt − R ft ) + s i ( SMB t ) + et
Portfolio a t(a)
S/L -0.011 -2.675
S/M -0.004 -1.195
S/H 0.0006 0.187
C/L -0.013 -3.38
C/M -0.009 -2.178
C/H 0.002 0.5155
B/L -0.009 -2.762
B/M -0.005 -1.513
B/H -0.0003 -0.092

(d) R pt − R ft =αi + bi ( Rmt − R ft ) + hi ( HML t ) + et

Portfolio a t(a)
S/L 0.021 3.728
S/M 0.011 2.053
S/H 0.011 2.385
C/L 0.001 0.232
C/M -0.0006 -0.135
C/H 0.009 2.299
B/L 0.0004 0.139
B/M -0.0007 -0.187
B/H 0.007 0.222

(e) R pt − R ft = αi + bi ( Rmt − R ft ) + si ( SMB t ) + hi ( HML t ) + et

Portfolio a t(a)
S/L 0.002 0.441
S/M -0.004 -1.048
S/H -0.004 -1.383
C/L -0.007 -1.710
C/M -0.009 -2.007
C/H 0.001 0.291
B/L -0.001 -0.375
B/M -0.003 -0.844
B/H -0.002 -0.810

25
5. Summary and conclusion

Having systematically and robustly tested the relevance of Fama- French three-factor

model in explaining the cross sectional differences in portfolio returns, in the Indian

context using a hitherto large sample data pooled from wide range of companies and

periods, this section summarizes the findings herein below:

1. There is a strong size and value effects in Indian stock market. The difference

between the mean returns for small and big size stocks (SMB) is about 11% on an

annualized basis. Whereas, the difference between the mean returns for high and

low value stocks (HML) is about 12% on an annualized basis. The evidence

shows that the value stocks outperform the size stock. The result is inconsistent

with the findings of Sehgal (2003).

2. The pearson’s correlation between market and SMB and SMB and HML is

significant at 1% level. Whereas, the correlation between Market and HML is

significant at 5% level. The correlation result suggests some overlapping amongst

the factors and hence, explanatory factors are not orthogonal to each other.

3. The Fama-French three-factor model explains the cross section of average stock

returns that is missed by single Index model. The mean adjusted R2 improves

from 40.63% for single factor model to 61.2% for the Fama French model. The

mean absolute alpha (extra-normal return) declines from 0.0051 per month for

one factor model to 0.0036 per month for the multi-factor model.

26
We observe that overall the FF three-factor model explains the variation in cross section

of stock returns in a meaningful manner. We also note that the three-factor model is

robust in the sense that the value of alpha intercept is statistically insignificant in the case

of most of the portfolios. Our results are consistent with the findings of FF (1996) for US

portfolios and Sehgal (2003) for Indian stock market and provide evidence of the

pervasiveness of the FF three-factor model in explaining the return generating process.

Consequently, we reject the data snooping hypothesis, arguing that if the FF (1996) were

involved in data snooping, our empirical findings would have contradicted their results.

Our empirical findings are based on different time periods as well as on different sample

of securities than in Sehgal (2003). In summary, this study provides support for a

broader, rational asset pricing model in which there are multiple risk factors.

27
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30
 Appendix I

Single Index Model

Sharpe (1963) develop single index model. The single index model states that co-

movement between stocks is due to single factor. The basis equation underlying the

single index model is:

R j =αj +βj ⋅ f ------------------------------------------------------------------ (i)

Where:

Ri = Return on the jth stock

αj = Component of security j that is independent of factor performance

βj = Coefficient that measures change in Ri given a change in f

f = Rate of change in factor f

The term αj in equation (i) comprises of two elements αj which is the expected value

of αj and ε j which is the random element of αj

The single index model equation (i), therefore, becomes:

R j =αj +β j ⋅ f +ε j ------------------------------------------------------------------ (ii)

It is assumed that ε j and f are uncorrelated as are ε j and εk for j ≠k .

31