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A Note on the Impact of Portfolio Overlapping in Tests of the Fama and French Three-Factor Model

BP2-STS

    15.11.2012

33

Asset pricing
three-factor model
portfolio overlapping
size effect
value premium
English In the three-factor model of Fama and French (1993), portfolio returns are explained by the factors Small Minus Big (SMB) and High Minus Low (HML) which capture returns related to firm capitalization (size) and the book-to-market ratio (B/M). In the standard approach of the model, both the test portfolios and the factor portfolios SMB and HML are formed on the basis of size and B/M. This gives rise to a potential overlapping bias in the time-series regressions. Based on a resampling method and the split sample approach already proposed by Fama and French (1993), we provide an in-depth analysis of the effect of overlapping for a broad sample of European stocks. We find that the overlapping bias is non-negligible, contrary to what seems to be general opinion. As a consequence, the standard approach of applying the three-factor model tends to overestimate the ability of the model to explain the cross-section of stock returns.
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Faculty
Faculté des sciences économiques et sociales et du management
Language
  • English
Classification
Economics
Series statement
  • Working Papers SES ; 433
License
License undefined
Identifiers
  • RERO DOC 30622
  • RERO R007196426
Persistent URL
https://folia.unifr.ch/unifr/documents/302711
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