Forecasting Ability of Fama and French Three Factor Model Implications for Capital Budgeting英文文献.pdf

Forecasting ability of the Fama and French three-factor model Implications for Capital Budgeting July 2003 Abstract In the model-based estimation of the cost of capital, the common practice uses the average historical factor premiums as a proxy for the estimated factor premiums. But evidence shows that the common practice generates very inaccurate estimates. I propose an alternative way to estimate factor premiums by using business cycle variables. Based on the out-of-sample results from a simple trading strategy, my estimation procedure beats the common practice for both Fama and French three-factor model and the CAPM. Also, the Fama and French three-factor model performs better than the CAPM, at least in the short run. Moreover, the conditional mean dominance (CMD) confirms the better performance of Fama and French three-factor model under all the market situations. However, in the long run, neither asset-pricing model, using either estimation procedure, has good performance. As a result, at least in the short run, the Fama and French three-factor model with factor premiums estimated from business cycle variables should be recommended for capital budgeting decisions. JEL Classifications : G12, G31, C13, C22 Keywords: Asset pricing Models, Cost of Capital, Expected Returns, Trading Strategy * I. Introduction To evaluate the profitability of a project, most practitioners rely on an asset-pricing 1 model to estimate the cost