The Cross-Section Excess Returns: Risk Factors and Investor Sentiment

(ProQuest: ... denotes formulae omitted.)IntroductionRationality-based asset-pricing models assert that the cross-section of expected stock returns can be explained by betas or factor loadings on a set of common factors. Early evidence in the 1970s largely supports the Sharpe-Lintner-Black Capital Asset-Pricing Model (CAPM) and the Efficient Market Hypothesis (EMH) (Fama, 1991). Fama and French (1992), however, find that the main prediction of the CAPM, a linear cross-sectional relationship between mean excess returns and exposures to the market factors, is violated for the US stock market. In particular, exposures to two other factors, a size based factor and a Book-to-Market based (BM) factor, often called a 'value' factor, explain a significant part of the cross-section of equity returns.Based on these findings, Fama and French (1993) propose a three-factor model that expected stock return is linearly related to the factor loadings on returns of three portfolios constructed to replicate underlying risk factors-market factor, size factor and BM factor. These portfolios are excess return on market portfolio, Small Minus Big (SMB) size portfolio, and High Minus Low (HML) BM portfolio.The three-factor model of Fama and French has been used to explain most market anomalies (Fama and French, 1996), except the momentum anomaly initiated by Jegadeesh and Titman (1993). Carhart (1997) further includes a momentum factor constructed by the monthly return difference between the returns on the high and low prior return portfolios to capture the cross-sectional return patterns.In contrast, based on extensive psychological findings on the non-rational aspects of human beings, behavioral finance theories view these anomalies as a result of investors' irrationality (e.g., Lakonishok et al., 1994; Barberis et al., 1998; Daniel et al., 1998; and Hong and Stein, 1999).In this paper, we test whether the cross-section excess returns are due to risk factors or due to sentiment factor. First, we investigate the robustness of the four risk factors, which are market, size, book-to-market and momentum for equities listed on the Tunisian stock market over the period January 2001-December 2006. First, we focus on the ability of Fama and French three-factor model to explain the cross-section of stock returns and the returns of portfolios sorted by size and book-to-market equity. Second, we study the ability of the Carhart four-factor model to explain the stock returns, portfolios sorted by size and book-to-market equity returns, and portfolios sorted by size and momentum returns. Third, we study the relation between institutional investor sentiment and size portfolio returns. Finally, we investigate the influence of investor sentiment on market, size, value and momentum factors when they are associated in the pricing model.The paper also presents a review of literature and also the methodological approach. It gives a summary of descriptive statistics. The empirical results of three-factor model and the empirical results of four-factor model are also dealt with in the paper. It also reports the relation between sentiment and returns. It presents the empirical results of the four-factor model augmented by investor sentiment. Finally, it presents the conclusion.Literature ReviewThe cross-sectional variation in the equity returns constitutes an important subject of research for the recent financial literature. There is an ongoing debate concerning the underlying reasons for this variation. Roughly speaking, on the one hand, the stock excess returns are believed to be compensation for risk involved, whereas on the other hand they are attributed to investor sentiment.L'Her et al. (2004) test the Fama-French three-factor pricing model augmented by the momentum factor on the Canadian stock market over the July 1960-April 2001 period. They find that the average annual premium obtained for the market, size, book-to-market and momentum risk factors are, respectively, equal to 4. …

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