And the Winner is ... “CAPM, FAMA and French Three-Factor or Reward Beta”?

Abstract

The goal of this paper is to estimate and compare three alternative estimating models for predicting asset returns in Brazil and in the United States: 1) Sharpe-Lintner-Mossin CAPM model; 2) Fama and French three-factor model; 3) Reward Beta Model. In accordance with the Fama and French’s [1] and Bornholt’s [2] methodologies, the tests were carried out on portfolios and applied in two sub-samples of Brazilian and American stocks: The within-sample (1995:07 to 2007:06 in Brazil and 1967:07 to 2007:06 in the United States) and the out-of-sample (2007:07 to 2013:06 in Brazil and in the United States). The results of this study reinforce current perception that the CAPM and the three-factor model fall short to elucidate future returns in both countries. Our results also provide evidence that there is a systematic relationship between the Reward Betas and the excess return of the securities in Brazil and in the United States. Furthermore, the inclusion of the size and book-to-market factors amplifies the explanatory power of the Reward Beta Approach.

Keywords: Capital Asset Pricing Model; Fama-French three-factor model; Reward Beta Approach