Question
Consider the estimation of the CAPM and the Fama-French three-factor model: rit rf t = i + i(rM t rf t) + it, rit rf
Consider the estimation of the CAPM and the Fama-French three-factor model: rit rf t = i + i(rM t rf t) + it, rit rf t = i + i(rM t rf t) + siSMBt + hiHMLt + it. You analyze a stock, run the Fama-French regression above, and obtain the following estimates: i = 0.5%, i = 1.3, si = 0.3, and hi = 0.5. Suppose that regardless of which model you use, you obtain the same estimate for i . In particular, assume that the stocks sensitivity to the market risk, i , is the same in both the CAPM and the Fama-French model. Assume that E[rM trf t] = 8%, E[SMBt ] = 4%, E[HMLt ] = 6%, and the current risk-free interest rate rf = 3%.
a) What is the required rate of return on the stock if the Fama-French model holds? What is the expected rate of return on the stock?
b) What is the required rate of return on the stock if the CAPM holds?
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