Assignment 4

Calculating RRR with FF model;

Comparing FF model with CAPM

Marks = 4

Note:

A.  The following assignment must be done in group of 3.

B.  The due date is December 2, 2008. Try to submit the assignment on due date otherwise 0.5 mark will be deducted per day.

C.  If you miss this assignment, make up assignment will be for 10 small and 10 large, 10 high B/M stocks and 10 low B/M stocks with two years monthly data

D.  You are advised to comprehend each step thoroughly so that you answer any question at the time of submission. Those who fail to answer the questions will face penalty of 2 marks.

E.  Assignments similar in contents, format, and explanation, will not get any mark

ASSIGNMENT

Select the same company which you had selected in the CAPM assignment. You may use the previous data that you used in the CAPM assignment.

Needed:

1. Calculate required rate of return (RRR) on the stock of your selected company by using Fama and French (FF) model

2. Compare CAPM with FF model and decide which model can better predict the required rate of return on your selected security. In other words, based on your analysis tell which model is more realistic.

For doing the assignment, follow these steps:

1. Sort in descending order the KSE 100 index companies on the basis of market capitalization and select top 5 companies  and bottom 5 companies

2. Obtain end of month closing share’s prices for these companies for 12 months. These months should correspond to the year and months that you had selected in the CAPM assignment

3. Calculate monthly returns for both large and small firms, then average the returns and find the difference between average returns of small and large firms. This will be your SMB (small minus big)

4. For calculating HML premium, calculate the book to market ratio of KSE100 companies, sort firms on the basis of this B/M ratio in ascending order, select top 5 companies and bottom 5 companies.

5. Obtain share prices of these companies for matching periods as mentioned above, calculate monthly returns and find out the monthly difference between the average returns of high and low B/M firms. This will be your HML

6. Run multiple regression with (Ri-Rf) being your dependent variable (y) and three independent variables namely (Rm-Rf), SMB, and HML (x variables)

7. Find out beta of each variable and then put these betas into Fama and French three factor model RRR = Rf+B(Rm-Rf)*+B(SMB)**+B(HML)***

8. Compare this RRR with the RRR calculated with CAPM model

9. Decided whether CAPM or Fama and French model gives you RRR more close to actual values. In other words, based on your analysis tell which model is more realistic.

Note:

* This is the annual risk premium on market portfolio. Simply add up all the monthly Rm-Rf value and you will get the annual Rm-Rf

** This is the annual size premium which you can obtain by adding up all the SMB values in all of the 12 months

*** This is B/M ratio premium and cab be obtained by adding up the HML values of all of the twelve months

Data Sources: