The effect of macroeconomic variables on the robustness of the traditional Fama-French model. A study for Mexico using different portfolios.

AutorSaucedo, Eduardo
  1. Introduction

    The Fama-French Model (1992) (FFM) is a well-known asset pricing model in finance that uses size, book-to-market equity and other variables such as beta (market size), leverage and earning-price ratios to capture the stock return of different companies. In the original study, the authors claim that beta has little or even no ability to explain cross-sectional variation in equity returns, but variables such as book-to-market value and market firm capitalization (firm size) can explain such variation.

    Empirical evidence suggests that, in some cases, FFM has been successful in helping to predict the financial markets, but investors have been interested in creating more sophisticated models to better predict the performance of the stock market. Therefore, in the last few years, some extensions of the FFM have emerged. Besides the traditional variables included in the FFM, Fama-French extensions comprise the inclusion of variables related to either macroeconomic conditions or firm performance, such as momentum, profitability, dividends, fundamentals, etc. Studies by Bali et al. (2015), Aretz et al. (2005), Adcock et al. (2019) and Bergbrant and Kelly (2016) are good examples of Fama-French extensions that include macroeconomic conditions, while studies by Roy and Shijin (2018) and Djamaluddin and Roffi (2017) are extensions that include variables related to firm performance.

    Regarding the literature about Mexico on this matter, only a few research studies have applied either the traditional or an extension of the FFM to analyze the performance of the Mexican Stock Market. Most of such literature centers its analysis on the FFM and just adds the interest rate as anadditional explanatory variable, asfound in Velarde (2004) and Trevino (2011). To the best of our knowledge, there are no other research studies that apply an extended version of the FFM to analyze the performance of the Mexican Stock Market across different periods. The objective ofthis study isto provide some new evidence that contributes to the literature and at the same time provides important signals that can be helpful for investors interested in the Mexican Stock Market.

    The study divides the Mexican Stock Market into different portfolios, accordingtospecific characteristics that are explained in the following sections, and then applies the traditional FFM and an extended version of the same, which include some macroeconomic and financial variables recommended in the literature. The purpose of the extended version is to explore if the inclusion of economic fundamentals is helpful in creating a more robust econometric model to better predict stock market returns in Mexico. To explore how the 2008-2009 financial crisis affected local markets, the sample has been divided into two periods, one of them without the effect of the crisis. The study uses a database that spans from June 1997 to January 2018 and creates portfolios using Mexican stocks, according to the amount of the returns generated by firms in previous periods, as in Fama and French (1992).

    The structure of the study is as follows: Section 2 analyses relevant literature regarding the FFM applied to Mexico and international markets. Section 3 presents the methodology and econometric model implemented in this study. Results are presented in Section 4 and, lastly, Section 5 includes the discussion and conclusion parts of the research.

  2. Literature review

    This study is based on Fama and French (1992), which uses different portfolios classified according to market book value and the market capitalization of each firm. Different literature, such as O'Brien (2007) and Blanco (2012), supports the idea that by incorporating firms according to market firm capitalization and market book equity, FFM becomes more robust than the traditional Capital Asset Pricing Model (CAPM). One characteristic that makes FFM preferable to CAPM is that the latter incorporates only the market risk premium and disregards whether portfolios are made up of small or large firms or according to market value books.

    2.1 FFMin the Mexican Stock Market and other markets

    Velarde (2004) works on an extension of the FFM and develops an analysis with additional variables, such as unexpected inflation, exchange rate, long-and-short interest rate spreads, spreads between corporative and government bonds to identify if these risk variables help to explain returns in the Mexican Stock Market. The author concludes that those variables do not explain Mexican Stock Market behavior, since most of them are not statistically significant. Valencia-Herrera (2015) also implements the FFM and analyzes the performance of the Mexican Sustainability Index during the period from 1995 to 2012. Results indicate that such an index generated not only smaller returns but also smaller risk than the entire Mexican Stock Market. Results also indicate that market risk premium, beta market capitalization and year momentum beta are all statistically different from zero.

    Gomez (2006) analyzes the effect of local and external factors in the returns of different Mexican portfolios from 1995 to 2003. The author finds that the exchange rate is relevant to explain market returns, while country risk does not have any effect on them. Similarly, Trevinio (2011) examines the determinants of the Mexican Stock Market returns from 1994 to 2010. The author constructs Fama-French portfolios and finds that the exchange rate has a clear impact on risk returns. Trejo-Pech etal. (2012) analyze the Mexican Stock Market from 1991 to 2010 and implement the FFM. The study includes nine portfolios, and their results are aligned with stock market returns. However, when 25 portfolios are created, the model is no longer functional to predict stock market returns due to the small sample size in each portfolio.

    Regarding the literature about Latin America, Sanvicente et al. (2017) examine the Brazilian stock market from 2004 to 2014. The authors find that country risk is not statistically significant to explain stock returns. Duarte et al. (2013), in a study for Colombia during the period from 2004 to 2012, use a CAPM model to explain whether the firm size is relevant to determine the size premium in local stock markets. Their results indicate that size premium is not relevant; thus, the market does not award any premium for investing in either small or big companies.

    In the case of the United States (US), Aretz etal. (2010) develop an extended version of the FFM and incorporate additional variables to the traditional FFM model. They include macroeconomic variables such as economic expectations, unanticipated inflation rate, and changes in the spread between short- and long-term interest rates. They conclude that portfolios constructed according to book market value are overly sensitive to changes in economic fundamentals, while portfolios created according to firm capitalization value are more sensitive to changes in interest rate and exchange rate. Later, Fama and French (2015) developed a different study for the US stock market, from 1963 to 2013, where besides the variables from their seminal model, they include additional variables related to profitability and investment patterns. They create three portfolios and find that this new extended model explains between 71 and 94%, respectively, of the total variance generated by these portfolios.

    Among the relevant FFM literature that has been developed about Asia, Chiang et al (2017) analyze nine Asian stock markets from 1995 to 2015 and compare those using different variations of the traditional FFM. The authors include profitability, investment, momentum, P/E ratio and dividend yield variables. They find that FFM with eight explanatory variables is more effective to explain the performance of the stock market than the traditional FFM.

    Manjuantha and Mallikarjunappa (2018) use data from 1996 to 2010 to test the FFM in the Indian Stock Market. They find that portfolios composed of medium and high book value firms are well explained by the FFM, but portfolios composed of small book value firms only respond to market premium and not to the other two explanatory variables included in the model. Lastly, Chowdhury (2017), in an analysis for Bangladesh during 2010-2014, uses the Fama-French three-factor model. The main finding is that stocks with a small market capitalization value perform better than those with a large capitalization value. Results also indicate that big firms have an ambiguous effect on portfolio returns.

  3. Methodology and econometric model

    This study includes the stocks listed in the Mexican Stock Market. One limitation of this study is the small number of stocks available in the Mexican market, which reduces the possibility of creating well-diversified portfolios. This study includes 78 stocks [1], a number obtained after eliminating financial stocks, as well as the least liquid stocks listed in the stock market [2] (the stocks removed from the sample are from firms that were not listed during six consecutive months or whose market capitalization did not change in the same period). The database used in this study comprises monthly data from June 1997 to January 2018 [3]. The stock market data are obtained from Bloomberg and already include dividends. After robustness and residual tests in each regression, outlier data were removed from the sample when the results changed significantly between periods, or when residuals were located outside the confidence interval threshold. This allowed us to capture the general performance of the Mexican Stock Market in a better way.

    The study includes the financial risk environment prevailing in the country as an explanatory variable called country risk. Such variable is used to capture the exposure of the stock market to the country's risk factors. The country risk variable is expressed as the difference between the long-term Mexican bonds categorized in...

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