The Security Return Factor Effect On Economic Growth Based On Factor Model

Asset pricing has been a most researched topic in classical and modern finance.Capital Asset pricing Model (CAPM) is a well-researched topic and fundamentaltheory which still taught in the nowadays business schools. However, there are many anomalies existing in the financial markets that cannotexplain by the classical theory such as the CAPM, especially the size effect, value effect and momentum effect.According to Fama and French (2012), HML is used to explain the value effect, which the average return on value portfolios subtracts the average return on the growth portfolios, and SMB is used to explain the size effect, which is the average return on the small size firms portfolios subtracts the average returns on the big size firms portfolios. WML is used to explain the momentum effect, which the average return on the past winner portfolio subtracts the average returnon the past loser portfolio (Carhart, 1997). Momentum in a stock is described as the tendency for the stock price to continue rising if it is going up and to continue declining if it is going down. The MOM can be calculated by subtracting the equal weighted average of the highest performing firms from the equal weighed average of the lowest performing firms, lagged one month (Carhart,1997). Liew and Vassalou (2000) use these returns factors of HML, SMB and WML to explain the future economic growth, namely the GDP growth. They found that except for WML, HML and SMB do contain significant information regarding to future economic growth in some countries. In addition, Vassalou (2003) use factors mimicking portfolio to create a GDP factor to represent the "news related to future GDP growth. Together with the GDP factor, Vassalou (2003) found that HML and SMB become redundant and contain no information in explaining the stocks returns. Then she concludes that the reasons why HML and SMB factors are able to explain the stocks returns is that they contain "news related to future GDP growth" information.The purpose of this dissertation is two-fold. First, I will follow the methods of Liew and Vassalou (2003) to model the GDP growth using return factors in UK, US and China. The return factors are Fama and French’s HML, SMB factors and Carhart’s WML factor. Also, I will include business cycle variables such as term spread and default spread to investigate whether returns factors are still valid to explain GDP growth. The results suggest that HML is still justifiable to explain UK GDP growth, but HML, SMB and WML generally lose explanatory power on US and Chinese GDP growth.Second, I will follow the methods of Vassalou (2003) and use factors mimicking portfolio to create the GDP factor to test and compare the models performance. The empirical models are Fama and French three factors model and the GDP factor model. The results indicate that the GDP factor does have explanatory power on the stocks returns.