Examining the Impact of the Market Risk Premium Bias on the CAPM and the Fama French Model

Open Access
Author:
Dorian, Chris Paul
Area of Honors:
Finance
Degree:
Bachelor of Science
Document Type:
Thesis
Thesis Supervisors:
  • Timothy T Simin, Thesis Supervisor
  • James Alan Miles, Honors Advisor
Keywords:
  • Risk Premium
  • Fama French
  • Fama-French
  • CAPM
  • Asset Pricing
  • Beta
  • Investments
  • Portfolio Management
  • Finance
Abstract:
The Capital Asset Pricing Model and the Fama French Three Factor Model are widely considered two of the premier financial asset pricing models. The Fama French Model uses three factors, SMB, HML, and Market Premium, to predict stock returns. It was created as an extension to the Capital Asset Pricing Model, which only considers one factor, the Market Premium. Glenn Pettengill, Sridhar Sundaram, and Ike Mathur observed that the Capital Asset Pricing Model has a flaw in that it relies on the positive relationship between risk and return but does not consider that an inverse relationship exists when the market premium is negative. Pettengill et al. note that this flaw creates a market risk premium bias within the model. This paper utilizes a similar method as Pettengill et al. to determine that the same flaw exists for the Fama French Model. It then determines that the Fama French Model is better that the Capital Asset Pricing Model at reducing the impact of the market risk premium bias.