CAPM and Fama-French Three-Factor Model: A Dual Examination of Risk-Return Predictive Capabilities in the Bangladesh Capital Market

Abstract

This study investigates the impact of different risk factors on stock returns in the Bangladesh capital market by empirically testing the Capital Asset Pricing Model (CAPM) and the Fama-French Three-Factor Model. The aim is to conduct a comparative analysis to determine which model better explains stock returns in an emerging market like Bangladesh, known for its volatility, inefficiency, and instability. While CAPM and Fama-French models are extensively tested in developed markets, their application in Bangladesh remains underexplored. This research fills that gap by analyzing monthly returns from 170 securities listed on the Dhaka Stock Exchange from 2009 to 2023. The study forms ten portfolios based on a wide spread of estimated betas and examines whether the relationship between expected return and risk is linear. While the CAPM showed significant results across all portfolios, the relationship between mean excess return and beta was linear but negative, attributed to negative average market returns during the study period. The Fama-French Three-Factor Model, tested with 110 companies from 2014 to 2023, utilized a 3x3 sort methodology based on size and book-to-market equity factors. This model demonstrated higher explanatory power, with a 60.58% improvement over CAPM and only 0.7% of excess returns not explained by the factors. GRS test statistics further indicated that while both models rejected the null hypothesis over the entire period, the Fama-French model performed better in sub-period analyses, suggesting superior accuracy in capturing stock returns in the Bangladesh market. Overall, the findings highlight the Fama-French Three-Factor Model as more effective than the CAPM in explaining portfolio excess returns in this emerging market context.