FAMA FRENCH METHODOLOGY ON THE NIGERIAN CAPITAL MARKET
This study investigates the impacts of Fama French methodology on the Nigerian capital market.
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CHAPTER ONE
INTRODUCTION
1.1 Background of the Study
Nobel Laureate Eugene Fama and researcher Kenneth French, former professors in Finance at the University of Chicago booth school of business, attempted to better measure market returns and through research found that value stock outperform growth stock since then this study has led to a series of controversy amongst them. In the year 1993, Eugene Fama and Kenneth French present their model (hereafter called FF3FM). The Fama and French model have three-factor; the size of firm, book-to-market value and excess return on the market. In other models, the three factors used are SMB (small minus big), HML (high minus low) and the portfolio’s return less the risk-free rate of return. SMB accounts for publicity traded companies with small market caps that generate higher returns, while HML accounts for value stock after high book-to-market ratios that generate higher returns in comparison to the market. The Fama French 3 Factor model is an asset pricing model by adding size risk and value risk factors to the market risk factors. The traditional asset pricing model, known formally as the capital asset primary model [CAPM], uses only one variable to describe the returns of the market as a whole. In contrast, the Fama-French model uses three variables. Fama and French started with the observation that two classes of stocks have tended to do better than the market as a whole: (i) small caps and (ii) stocks with low price-to-book ratios (PIB, customarily called value stocks, contrasted with growth stock).
The Nigeria capital market is a network of financial institutions and infrastructure that interact to mobilize and allocate long-term funds in the economy. The market affords business firms and government the opportunity to sell stocks and bonds, to raise long-term funds from the savings of other economic agents. The Nigeria capital market is a highly specialized and organized financial market and indeed an essential agent of economic growth because of its ability to facilitate and mobilize saving and investment. According to Al-Faki (2006), the capital market institution is essential to the economic growth of any nation. The Nigeria capital market is a network of specialized financial institutions, series of mechanisms, processes and infrastructure, that in various ways, facilitates the bringing together of suppliers and users of medium and long-term capital for investment in socio-economic developmental projects. The capital market provides a means through which this is made possible. However, the paucity of long-term capital as posed the greatest predicament to economic development in most African countries. Capital provides the impetus for the effective and efficient combination of factors of production to ensure sustainable growth and development.
The concern about the unbelievable crash in equity prices in Nigerian stock market seems to be directed mainly towards the firm-specific, market and economic fundamentals. That is, most market participants link stock market price decline to changes in output growth, exchange rate, business earnings, inflations rate, and market rate of returns, government spending and money supply. The need to find out what is actually responsible for the equity market price movement under the bull and bear market cycle has generated more interest and has necessitated the need to integrate investors’ sentiment as a potential explanation for equity price movement in both emerging and developed markets. Edo (2005), pointed out that the 2002 stock market upward price adjustment in Nigeria was characterized by perceived irrationality. He attributed the high equity prices movement to the irrational behaviour of market participants especially in cases when market fundamentals were not strong.
The institutional frameworks through which the capital market functions in Nigeria include the Nigerian Securities and Exchange Commission (SEC), the Nigerian Stock Exchange (NSE), stockbrokers and investors. The main objective of establishing the Nigerian capital market was to mobilize savings from numerous economic units in the country for economic growth and development; provide adequate liquidity to investors, and to broaden the ownership base of assets as well as the creation of a buoyant private sector. It is important to state here that few works has been done on the relationship that exists between development of the capital market and fluctuations seen through various shocks in the economy and how it generally affects productivity. The study of economic fluctuations is seen in the concepts of business cycles. Mitchell (1927) defined business cycle as a sequence of expansions and contractions particularly emphasizing turning points and phases of the cycle. Lucas (1977) as contained in Kydland and Prescott (1990:2) defined business cycle as the statistical properties of the co-movements of deviations from the trend of various economic aggregates with those of real output. These definitions underscore the recurrence of upturns and downturns around the trend of macroeconomic aggregates.
Nigeria, no doubt, has witnessed periods of boom and also recessions. The deep crises that have pervaded the Nigerian economy since early 1970s posed considerable challenges to policymakers and economists. In the 1970s, the economy was expanding due to large inflow of crude oil income and by the period 1981-1985, at the wake of the falling oil revenue; the economy declined precipitating a rapid deterioration of the living standard of Nigerians. Iwayemi (1995:5) point out that the cycle of oil price booms and precipitous decline and the associated transfer problem in terms of the net resource outflow and debt repayments triggered profound changes unparalleled in the history of the economy. Macroeconomic indicators at the time point to the grave economic situations. In particular, there were sharp fluctuations in the gross domestic product (GDP), remarkable fluctuations in inflation rates, unemployment rate, growing size and composition of government expenditure and slow growth of the domestic production, chronic fiscal deficit, and decline in traditional agricultural output. These outcomes were traced to a multiplicity of exogenous and endogenous factors (shocks) which in the case of Nigeria could have combined to generate business cycles.
In Nigeria, the capital market has over the years been performing its traditional role. However, the efficiency and effectiveness in this regard have greatly being limited by various factors notable among which is the structure of the economy; which is dominated by oil production. Institutional frameworks of the capital market to effectively carry out its core purpose of its establishment have to be put in place to ensure that the expectations of both the lenders and users of funds are adequately met to induce savings and optimal investment necessary to economic growth and development.
Moreso, in Nigeria, a small number of studies tested the ability of the French and Fama three-factor model to predict variations in the rate of returns of stock and found that the French and Fama three-factor model is able to explain a sufficient amount of variations in the rates of returns. This study aims to answer questions about the FF3F’s significant power in explaining common variations in predicting the rates of return in Nigerian capital market. This will provide investors with satisfactory tools to analyze and predict stock prices and make accurate decisions. Therefore, the main objective of this study is to test the validity of the FF3F in the Nigerian Stock Exchange (NSE) and sought to find if this model is better in explaining the variations in the rate of return in NSE. This study is expected to provide information about systematic factors that expected to have an influence on the rates of return of stocks, to provide participants in NSE with useful information, which leads to improve their decisions, to provide investors in NSE with important information about some profitable investment strategy. Therefore, this research tends to investigate the impact of the Fama and French methodology as regards to the Nigerian capital market.
1.2 Statement of the Problem
In finance theory, it is generally accepted that the expected return of the market is positively and proportionally related to the conditional volatility meaning that if there are expectations of higher level of risk associated with a particular investment than greater returns are required as compensation for that higher expected risk. However, the existing empirical evidence on risk and return has drawn conflicting conclusions suggesting the existence of additional factors that are relevant for asset pricing. It appears that much of the theory has difficulty, capturing the actual behavior of asset pricing, as numerous persistent patterns in stock return that contradict these rational models have been documented. Fama and French factors are an extension of the capital asset pricing model. Connor and Seghal (2001) found that market return, market size and market value all had significant effect on firms return in the Indian stock market.
Varun Kapur (2007) found excess market return to be the most significant variable in explaining the cross-section of average industry returns. The two other factors in the model were significant but have varying effects on the different industries and are not consistent in their effect on an industry over different periods. They therefore found the Fama-French model successful in explaining excess industry returns across time period and as well as for industrial sub-time periods because they discovered that large part of the variance in this factor effect is explained by differences in the relevant firm characteristics of average. Qi (2004) compare the predictive power of the CAPM and Fama-French (FF3FM) using data from the United State for 80years and grouped the data into two industries and found that model neither model had overall advantage on the other. In the course of this study, the agricultural industry of the Nigerian capital market would be used as a tool to investigate the impact of the Fama-French three-factor model in relation to the size, value and expected returns of the industry. Therefore this study stands to evaluate the impact and effect Fama-French methodology has in the Nigerian capital market.
1.3 Purpose of the Study
The major aim of this study is to investigate the impact of Fama French methodology on the Nigerian capital market.
The specific objectives are as follows;
- To identify if the market risk premium of the Fama-french model predicts the Nigerian capital market.
- To examine if the SMB market capitalization factor works for the Nigerian capital market.
- To examine the relationship between the HML book-to-market ratio of the Fama-french model and the Nigerian capital market.
1.4 Research Question
- To examine the relationship between the risk-free rate of return and the Nigerian capital market. Expected return
- To examine SMB market capitalization factor in the Nigerian capital market. Expected return.
- To examine the relationship between the HML book-to-market ratio and the Nigerian capital market. Expected return.
1.5 Hypothesis
Ho1; There is no significant relationship between the market risk premium of Fama-French model and the Nigerian capital market.
Ho2: There is no significant relationship between the SMB market capitalization factor and the Nigerian capital market.
Ho3: There is no significant relationship between the HML book-to-market ratio and the Nigerian capital market.
1.6 Significance of the study
This study will be of great importance to the financial analyst out there, the government, various investors, businessmen and all partakers of the capital market as it will aid in promoting the capital market. The outcome of this study will also serve as a reference material to students in various field of studies and also contribute to the stock of existing literature.
The policymakers will also find this work useful in understanding the potential causes of stock market booms or crashes and how non-market fundamentals such as investors’ sentiment can drive equity market prices. Stock Market regulators as policymakers will find the results helpful in formulating and implementing stock market intervention policies that could prevent bull and bear market from destroying shareholders’ wealth.
This study would also be relevant to investment and professional money/asset managers, as it would provide a better explanation for short and long-run factors that are responsible for the movement in equity prices in an emerging capital market such as the Nigerian stock market. It will also assist them in identifying investment approaches, pursuing available investment opportunities and reducing the probability of high-value losses in the market.
Lastly, business owners and managers will also benefit from this study as it would provide insights into the stock price movement under a bull and bear market cycle. This will enable them to determine the best stock market and economic condition that will favor listing their shares on the exchange.
1.7 Scope of the Study
This study concerns itself with the investigation of the Fama-French three-factor model and its impact on the Nigerian capital market from 2008 to 2014 on a yearly basis for each year.
1.8 Limitations of the Study
The major constraints to this study are attributed to the limited time available for the research work. However, available time and available resources were utilized effectively and efficiently to ensure that the research work is completed within the expected period of completion.
1.9 Organization of the Study
This study is made up of five chapters. Chapter one is an introduction, statement of the problem, research question, formulation of hypothesis, the significance of the study, definition of terms and organization of the study. Chapter two is concerned with the review of the literature. In chapter three, the methodology is presented. Chapter four concerned itself with data presentation, analysis, and interpretation of results. While in chapter five the discussion of findings, conclusion, and recommendation is presented.
1.10 Definition of Terms
SMB (Small minus Big): is one of the three factors in the Fama French stock pricing model; it’s used to explain portfolio returns. This factor is also referred to as the “small firm effect,” or the “size effect,” where size is based on the company’s market capitalization.
HML (High minus Low): also referred to as a value premium, is one of three factors in the Fama and French asset pricing model. HML accounts for the spread in returns between value and growth stocks and argues that companies with high book-to-market ratios, also known as value stocks, outperform those with lower book-to-market values, known as growth stocks.
Growth Stocks: These are stocks that have great potential for outperforming similar stocks in a similar industry. They are associated with successful companies whose earnings are expected to continue growing at an above-average rate relative to the market. Growth stocks are overvalued and usually have high price-to-earnings ratios and high price-to-book ratios.
Value Stocks: are undervalued stocks, they tend to trade at a lower price relative to their fundamentals (including dividends, earnings, and sales). They generally have low current price-to-earnings ratios and low price-to-book ratios.
Rate of Returns: The annual income from an investment expressed as a proportion (usually a percentage) of the original investment. It comprises any change in the value of the investment, and/ or cash flows which the investor receives from the investment.
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