Chapter 11.3 Additional slides on FF

SMB and HML Average SMB > 0 over the long term Average HML > 0 over the long term Why should there be a size premium (i.e., why should small-cap stocks have a higher return over the long term)? 8/25/2014 2

Why is there a value premium? Why should value (high B/P) stocks have a higher return than growth (low B/P) stocks over the long term? Explanations from two different schools of thought Chicago school Risk-based explanation Behavioural finance 8/25/2014 3

Chicago School No free lunch plan In an efficient market, there is always a risk/return tradeoff If a premium exists for value stocks, it must be because they are riskier However, their standard deviations (of returns) are typically not higher than that of growth stocks Fama-French’s verbal explanation: value stocks are in distress (earnings are temporarily depressed), and therefore riskier 8/25/2014 4

Risk-Based Explanations Petkova and Zhang (2005), Zhang (2005) Allow beta to vary over time, in particular, over the business cycle, in their model Value companies have greater amounts of tangible capital, and the latter tends to be irreversible (difficult to scale back, or difficult to divest). Hence: In a recession, value firms suffer from excess capacity During market downturns, value stocks have more systematic risk Value stocks are therefore riskier in this sense 8/25/2014 5

Behavioural Explanation Behavioural finance will be covered in the last class Explains why growth stocks underperform Investors overreact to “glamour” stocks High valuations not justified or sustainable Bubble eventually bursts 8/25/2014 6