Question

1a. In studying the EMH, what did Fama and French conclude? Are there anomalies? If so how can these be explained?

b.Fama and French found that high book-to-market firms outperform low book-to-market firms even after adjusting for beta. What are the implications in terms of the EMH?

information: The efficient market hypothesis (EMH), a hypothesis that states that share prices reflect all information and consistent alpha generation is impossible. According to the EMH, stocks always trade at their fair value on exchanges, making it impossible for investors to purchase undervalued stocks or sell stocks for inflated prices

this is the only information i have

Answer 1

As per French Fama Model (FFM)

Ri = Rf + beta1*(Rm - Rf) + beta2*SMB + beta3*HML

Ri: return on security/portfolio

Rm - Rf: market risk premium

SMB: Returns of small company - big company (size in terms of market capitalization)

HML: Returns of company with high book/price value - low book/price value

As per FFM the statistical coeff beta1, beta2 & beta3 were all statistically significant & positive.

beta2*SMB : this term means that small companies will provide higher returns as compared to larger companies due to higher growth in earnings small companies will observe in initial years

beta3*HML: this term means that small companies with high book value/market value (ie undervalued companies) will provide higher returns as compared to companies with low book value/market value (ie over valued companies)

Anomaly with EMH:

beta2*SMB : The market is very efficient to discover high growth small companies & will pump in money in these small companies to make them big, and thus reduce the excess growth return small companies have very quickly

(b)

As per Fama & French model, the concept being referred to is value buying. High book to market value firms are those firms which are undervalued. The market price of the stock is less than the book value of the stock (ie value of equity from the balance sheet). These stocks have been beaten down the market due to some difficulties the companies might be facing in the near term. But it is possible that the turnaround of the companies can be done (as their equity value from the balance sheet remains strong). Once the turn-around happens, equity value of these firms start rising sharply, providing very good returns.

Low book to market value firms are those firms which are overvalued. The market price of the stock is much higher than the book value of the stock (ie value of equity from the balance sheet). These stocks have been overvalued by the market due to high % increase in the earnings forecast of the companies in near future. But as the market realizes, such aggressive assumption of high earnings is not possible, these stock tend to correct giving lesser returns.

Implications in terms of EMH (efficient market hypothesis) is that market will tend to buy High book to market value firms till they reach low book to market value zone & market will sell low book to market value firms till they reach high book to market value zone.