Crucial to the interpretation of the Fama and French three-factor model is the question of whether the book-to-market equity ratio should be assigned as a ‘risk-based,’ as opposed to a ‘mispricing’ explanation of share price formation. In the context of Australian stock markets, we examine the role of the book-to-market equity ratio in the formation of stock returns. Notwithstanding the distinctive characteristics of Australian markets, our findings are complementary with findings for U.S. stocks. We succeed in revealing a strong association between stock returns and the firm’s book-to-market equity ratio, and find strong evidence that the association derives from the book-to-market ratio’s absorption of the implications of market leverage as a risk factor. In addition, we determine evidence of mispricing as contributing to the formation of market leverage itself.
Get full access to this article
View all access options for this article.
References
1.
Arnott, R.D., Hsu, J., & Moore, P. ( 2005). Fundamental indexation. Financial Analysts Journal, 61, 83-99.
2.
Bhardwaj, R.K. & Brooks, L.D. ( 1992). The January anomaly: Effects of low share price, Transaction Costs, and Bid-Ask Bias. The Journal of Finance, 47, 553-575.
3.
Chan, K.C. & Chen, N. ( 1991). Structural and return characteristics of small and large firms. Journal of Finance, 46, 1467-1484.
4.
Dempsey, M. ( 2009). The Fama and French three-factor model and leverage: Compatibility with the Modigliani and Miller propositions. Available at SSRN: http://ssrn.com/abstract=1350248.
5.
Durack, N.R., Durand, R.B., & Mailer, A. ( 2004). A best choice among asset pricing models? The conditional CAPM in Australia. Accounting and Finance, 26, 1-17.
6.
Durand, R., Limkriangkrai, M., & Smith, G. ( 2006). In America’s thrall: The effects of the US market and US security characteristics on Australian stock returns. Accounting and Finance, 46, 577-604.
7.
Faff, R. ( 2001). An examination of the Fama and French there-factor model using commercially available factors. Australian Journal of Management, 26, 1-17.
8.
Faff, R. ( 2004). A simple test of the Fama and French model using daily dataAustralian evidence. Applied Financial Economics, 14, 83-92.
9.
Fama, E. & French, K. ( 1992). The cross-section of expected stock returns. Journal of Finance, 47, 427-465.
10.
Fama, E. & French, K. ( 1993). Common risk factors in the returns on stocks and bonds . Journal of Financial Economics, 33, 3-56.
11.
Fama, E. & French, K. ( 1995). Size and book-to-market factors in earnings and returns . Journal of Finance, 50, 131-155.
12.
Fama, E. & French, K. ( 1996). Multifactor explanations of asset pricing anomalies. Journal of Finance, 51, 55-84.
13.
Fama, E. & French, K. ( 1997). Industry costs of equity. Journal of Financial Economics, 43, 153-193.
14.
Fama, E. & French, K. ( 1998). Value versus growth: The international evidence. Journal of Finance, 53, 1975-1999.
15.
Fama, E. & French, K. ( 2007). The anatomy of value and growth stock returns. Financial Analysts Journal, 63, 44-54.
16.
Fama, E. & MacBeth, J. ( 1973). Risk, return and equilibrium: Empirical tests. Journal of Political Economy, 81, 607-636.
17.
Gaunt, C. ( 2004). Size and book to market effects and the Fama French three-factor asset pricing model: Evidence from the Australian stockmarket. Accounting and Finance, 44, 27-44.
18.
Gharghori, P., Chan, H., & Faff, R. ( 2007). Are the Fama-French factors proxying default risk? Australian Journal of Management, 32, 223-249.
19.
Halliwell, J., Heaney, R., & Sawicki, J. ( 1999). Size and book to market effects in Australian share markets: A time series analysis. Accounting Research Journal, 12, 122-137.
20.
Kothari, S.P., Shanken, J., & Sloan, R.G. ( 1995). Another look at the cross-section of expected returns’ , Journal of Finance, vol. 50, pp. 185-224.
21.
Kross, W. ( 1985). The size effect is primarily a price effect. Journal of Financial Research, 8, 169-179.
22.
Lakonishok, J., Shleifer, A., & Vishny, R.W. ( 1994). Contrarian investment, extrapolation, and risk. Journal of Finance, 49, 1541-1593.
23.
Lally, M. ( 2004). The Fama and French model, leverage, and the Modigliani-Miller propositions. Journal of Financial Research, 27, 341-349.
24.
Merton, R.C. ( 1973). An intertemporal capital asset pricing model. Econometrica, 41, 867-887.
25.
Modigliani, F. & Miller, M. ( 1958). The cost of capital, corporation finance and the theory of investment. American Economic Review, 48, 261-297.
26.
Modigliani, F. & Miller, M. ( 1963). Corporate income taxes and the cost of capital: A correction . American Economic Review, 53, 433-443.
27.
O’Brien, M., Brailsford, T., & Gaunt, C. ( 2008). Size and book-to-market factors in Australia. 21st Australasian Finance and Banking Conference 2008 Paper. Available at SSRN: http://ssrn.com/abstract=1206542.
28.
Peterkort, R.F. & Nielson, J.F. ( 2005). Is the book-to-market ratio a measure of risk? Journal of Financial Research, 28, 487-502.
29.
Ross, S.A. ( 1976). The arbitrage theory of capital asset pricing. Journal of Economic Theory, 13, 341-360.
30.
Vassalou, M. & Xing, Y. ( 2004). Default risk in equity returns. Journal of Finance, 59, 831-868.
