A Comparative Analysis of Four-Factor Model and Three-Factor Model in the Nigerian Stock Market

Abstract

The study investigates if the three-factor model explains variation in expected returns of stocks on the Nigerian Stock Exchange (NSE); and also ascertains if the four-factor model explains the variation in expected returns of stocks on the NSE better than the three-factor model. The study use a sample size of 139 stocks with continuous trading on the NSE for the period January 2007 to December 2014 to construct 10 portfolios on the bases of size, value and returns. By means of multiple OLS regression analysis method with the aid of StataC13 software the analysis was done. The empirical analysis reveals that the three-factor model explains cross sectional variation in expected returns in the NSE. Also, the study shows that the size effect, value effect as well as momentum effect is present in the market. Comparing the four-factor model with three-factor model, shows that the four-factor model have better explanatory power than the three-factor model in explaining returns in the Market. It is recommended that equity investors, fund/portfolio managers and investment advisers should embed in their operational strategies the explanatory power of market beta, size and value as well as momentum on stock/portfolio returns to enable them build up trading strategies that minimize loss and maximize returns. Market regulators and policy makers should ensure appropriate measures are in place to improve market viability and liquidity in order to enhance the depth and breathe of the market.

How does the six-factor model do in explaining the relationship between return and risk on the Indonesia stock exchange?

“…Research from Carhart (1997), The four-factor model used 4 factors in explaining portfolio and return, namely, market return, firm size (SMB, Small Minus Big), book to market equity (HML, High Minus Low) and, momentum (WML, Winner Minus Loser). Research conducted by (Candika, 2017); (Evbayiro-Osagie and Osamwonyi, 2017) on the Nigerian capital market, (Nugraha and Susanti, 2019) on the Indonesian are in line with Carhart's (1997) research where four-factor explains stock returns better and clearer when compared to the three-factor. Fama and French (2014) again conducted a research to improve the previous model.…”

ESG and Firm Risk: Evidence in Korea

“…Subsequently, the four-factor model was further expanded to include the momentum factor, ultimately displaying a lower pricing error than the three-factor model [38]. This improvement was also reported in other studies [39,40].…”