How to Use the FamaFrench Model in Practice

1
How to Use the Fama-French Model in Practice

• How to Find
• Factor Loadings ( betas)
• Cost of capital ( expected return)

2
CAPM-type Regression

• Pull off the data for SP 500 data (the market)
  and your stock. Merge into the same spreadsheet
• Regress
• (Dependent variable, y-axis) excess returns
  ri-rf of your stock
• AGAINST
• (Independent variable, x-axis) excess returns
  rM-rf of the market
• Recall that for short horizons (daily, weekly)
  its okay to use raw returns rather than excess
  returns

3
Estimating CAPM

• What does Excel do?
• Objective Find the line that fits the best
• Fits the best criteria
• ? ei 0
• Minimize ? (ei )2

4
To find expected return

• Plug the beta you find into the following
  equation, where rf is the current risk-free rate
• Two approaches for Markets risk premium
• Use historical data (assume historical risk
  premia future risk premia)
• Use some other economic argument to come up with
  a reasonable risk premium going forward
• Well do this in April

5
Fama-French Regression

• Involves 3 independent variables
• Rm-Rf, the market premium (as in CAPM)
• HML, the return on high book-to-market firms
  minus low book-to-market firms
• SMB, the return on small firms minus the return
  on large firms
• Recall that HML and SMB should plot on the SML
  according to the CAPM
• They should therefore be useless for predicting
  returns
• They arent useless

6
FAMA Regression

• Pull off the data for RM-RF, HML and SMB from Ken
  Frenchs website
• Pull off the data from Yahoo! Finance for your
  stock. Merge into the same spreadsheet
• Regress
• (Dependent variable, y-axis) excess returns
  ri-rf of your stock
• AGAINST
• The three independent variables.

7
Two warnings / Excel tricks

• Ken French puts his data in the form of a text
  file
• not .csv or .xls
• Yahoo! and Ken French put their data in reverse
  order
• Old to new, vs. new to old

• Use Text to Columns
• Use sort

8
Warning three

• Be sure to line up date from Yahoo! With similar
  date from Prof. French.

9
To find expected return

• Plug the factor loading you find into the
  following equation, where rf is the current
  risk-free rate
• Use the same approaches as before
• Use historical risk premia, or come up with your
  own numbers.