There has been a lot of debate about whether the CAPM is a better model of expected returns than the Fama-French three factor model. Fama and French (1993) conduct time series tests of the CAPM and the three factor model using 25 portfolios formed based on size and book-to-market equity. The results of that paper suggest that the Fama-French model is superior to the CAPM. Let's say that you have been asked by your manager at Bank of America, Rosa Marks, to test the two models for 30 industry portfolios.

  

1. Explain what is it that you are testing and why so? If the CAPM (or three factor model) holds what would you expect to observe?

2. Which model would you say you prefer based on your analysis, and Why?

3. How many portfolios have statistically significant alphas at a 95% confidence level based on the CAPM and the Fama-French model? 

 

 SHOW ALL WORK,