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C alculating stock residual returns textbook page 118

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Unformatted text preview: f return, between 2 firms with same forecasted earnings, the price of the smaller firm will be lower, hence a smaller P/E ratio. When the small P/E group of small firms is tested for abnormal returns, it is not surprising to see that it will generate positive Jensen alphas, which are a reflection of the small firm risk premium, rather than market inefficiency. Thus it was important for Basu to control firm size in his study and confirm the existence of the P/E ratio effect. FAMA AND FRENCH (1992) BOOK TO MARKET RATIO (BMR) Fama and French formed a group of 10 portfolios and noted that average returns increased progressively from portfolio 1 containing the lowest BMR to portfolio 10 containing the highest BMR. Fama and French regressed the average returns of the 10 portfolios on sizes measured by market capitalization, BMR and beta risks, to control the effects of portfolio size and beta: ̅ In contrary to the semi-strong form efficient market hypothesis, the estimated coefficient of beta (b3) was found to be close to zero, contradicting the risk and return relationship proposed by CAPM. Furthermore, the estimated coefficient of BMR was significantly greater than 0, which suggested the persistence of the Book-tomarket ratio effect and the usefulness of this simple ratio in predicting portfolio returns. However, BMR has to be less than 1, because, if the market value of the company is higher than the book value, then an investor can potentially purchase the whole company, liquidate its assets and make a profit out of the exercise. In practice, lower share prices and negative sentiment can lead to higher BMR. Thus, the believes of market efficiency can argue that the linear relationship between average return and BMR is due to a financial distress premium demanded by investors, and this premium increases as the BMR increases. A similar study was performed by Kothari, Shanken & Sloan (1995) on a more recent set of data. This study found a weaker BMR effect and reaffirmed the significant relationship between betas and expected returns. 7 Cheryl Mew FINS2624 – Portfolio Management Semester 1, 2011 THE SMALL FIRM IN JANUARY EFFECT Keim (1983) made the follow unusual observations: In January, average exc...
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