analysis of three-factor model in the financial sector of the

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By

Pandu Megananda 11609007

BACHELOR’S DEGREE in

ACCOUNTING

FACULTY OF BUSINESS AND COMMUNICATION

SWISS GERMAN UNIVERSITY The Prominence Tower

Jalan Jalur Sutera Barat No. 15, Alam Sutera Tangerang, Banten 15143 - Indonesia

Revision after Thesis Defense on July 8^th 2020

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Pandu Megananda I hereby declare that this submission is my own work and to the best of my knowledge, it contains no material previously published or written by another person, nor material which to a substantial extent has been accepted for the award of any other degree or diploma at any educational institution, except where due acknowledgement is made in the thesis.

Pandu Megananda

_____________________________________________

Student Date

Approved by:

Dr. Ir. Yosman Bustaman, M. Buss.

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Thesis Advisor Date

Ir. Nurdayadi

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Thesis Co-Advisor Date

Dr. Nila Krisnawati Hidayat, S.E., M.M.

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Dean Date

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Pandu Megananda ABSTRACT

ANALYSIS OF THREE-FACTOR MODEL IN THE FINANCIAL SECTOR OF THE INDONESIAN STOCK EXCHANGE

By

Pandu Megananda

Dr. Ir. Yosman Bustaman, M. Buss, Advisor Ir. Nurdayadi, Co-Advisor

SWISS GERMAN UNIVERSITY

A multi-factor model is a financial model that is used to determine which factor plays a significant or influential role in affecting a certain portfolio’s returns. There are several problems that this paper aims to solve such as the asymmetric risk-reward ratio and the lack of influence of fundamental factors towards market returns. Accordingly, the objective of this paper is to prove the existence of risk-adjusted return and see whether the variables are statistically significant. Both objectives are accomplished by performing a regression using Fama and French Three-Factor model. The sample used in the study is publicly listed companies in the financial sector from 2008 to 2018. Previous studies have found that the use of three- and four-factor model to be significant in conclusion and practical in application. In brief, there are two steps that must be performed. First is to obtain the values that are used for the variables. Then the second step is to use the values from the first variable as the basis to construct the portfolios. Our findings of this study are: first, there is a risk-adjusted return (portfolio Alpha is positive), and second, the slope coefficients are -2.4 (MKT), -12.3 (SMB), and -4.9 (HML). Furthermore, one of the variables, SMB, which represents company size, is statistically significant.

Keywords: Three-Factor Model, Fama and French, Portfolio Alpha, Beta, CAPM Alpha, Market Capitalization, BM ratio, Financial Sector, Jakarta Composite Index.

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Pandu Megananda

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Pandu Megananda DEDICATION

I would like to dedicate this research for my parents. I would not be the man I am today without their untiring and devoted support. I also would like to dedicate this research for everyone who elected to go into finance at a rather early part of their life. The field of finance can be incessantly taxing, but rest assured you will be monetarily and intellectually compensated.

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Pandu Megananda ACKNOWLEDGEMENTS

I would like to thank all of the lecturers who had the chance to share their knowledge with me in all four years of my being a student here. Particularly, the accounting bunch. I was strucked by their camaraderie. It is no surprise that there are lecturers out there that can be so welcoming and warm that the line between student and lecturer can at times blurs. And I am grateful that I came across these people in my life. I do not wish to name names as it would imply that there is an order of influence. The events that transpired to SGU during my time as a student were undeniably profound. Their presence and amiability greatly helped me.

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Pandu Megananda TABLE OF CONTENTS

STATEMENT BY THE AUTHOR ... 2

ABSTRACT ... 3

DEDICATION ... 5

ACKNOWLEDGEMENTS ... 6

TABLE OF CONTENTS ... 7

LIST OF FIGURES ... 11

LIST OF TABLES ... 12

LIST OF EQUATIONS ... 14

CHAPTER 1 – INTRODUCTION ... 15

1.1. Background ... 15

1.2. Research Problems ... 16

1.3. Research Objectives ... 17

1.4. Significance of Study ... 18

1.5. Research Questions ... 19

CHAPTER 2 – LITERATURE REVIEW ... 21

2.1. Single-Index Model (1963) ... 23

2.2. Capital Asset Pricing Model (1964) ... 25

2.3. Three-Factor Model (1992) ... 27

2.3.1. Dependent Variable: Equal-Weighted Portfolio Returns ... 29

2.3.2. Portfolio Alpha... 29

2.3.3. Independent Variable 1: Market Factor (MKT Portfolio) ... 30

2.3.4. Independent Variable 2: Size Factor (SMB Portfolio) ... 31

2.3.5. Independent Variable 3: Value Factor (HML Portfolio) ... 31

2.3.6. Interpretation of the Three-Factor Model ... 32

2.3.6.1. Interpretation of Portfolio Alpha ... 32

2.3.6.2. Interpretation of Independent Variables ... 32

2.4. Four-Factor Model (1997) ... 33

2.5. Previous Studies ... 34

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2.7. Hypotheses ... 39

CHAPTER 3 – RESEARCH METHODOLOGY ... 40

3.1. Type of Study ... 40

3.2. Unit Analysis/Observation ... 40

3.3. Sampling Design ... 40

3.4. Location and Time Frame ... 42

3.5. Data Sources and Collection ... 43

3.5.1. Type of data ... 43

3.5.2. Data collection method ... 43

3.6. Research Model ... 43

3.7. Variable Operationalization ... 44

3.7.1. Risk-Free Returns ... 45

3.7.1.1. Definition of A Yield ... 46

3.7.1.2. Calculating the Yield ... 46

3.7.2. Market Returns... 47

3.7.3. Stock Returns, Excess Returns and One-Month Ahead Returns ... 48

3.7.4. Portfolio Analysis ... 50

3.7.4.1. Going Long and Going Short ... 50

3.7.5. Dependent Variable: Portfolio Excess Returns... 52

3.7.5.1. Example of Forming Dependent Variable: Portfolio Excess Returns . 52 3.7.6. Independent Variable 1: Market Factor ... 54

3.7.6.1. Beta ... 54

3.7.6.2. Estimating Beta and Alpha: One-Factor CAPM Regression... 54

3.7.6.3. Example of Estimating Beta ... 56

3.7.6.4. Forming MKT Portfolio ... 57

3.7.6.5. Example of Forming MKT Portfolio ... 57

3.7.7. Independent Variable 2: Size Factor ... 58

3.7.7.1. Calculating Market Capitalization ... 59

3.7.7.2. Example of Calculating Market Capitalization ... 59

3.7.7.3. Forming SMB Portfolio ... 60

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3.7.7.4. Example of Forming SMB Portfolio ... 61

3.7.8. Independent Variable 3: Value Factor ... 66

3.7.8.1. Calculating Book/Market ratio ... 66

3.7.8.2. Example of Calculating BM ... 66

3.7.8.3. Forming HML Portfolio ... 66

3.7.8.4. Example of Forming HML Portfolio ... 68

3.7.9. Final Step: Conducting a Regression based on Fama-and-French Three- Factor Model ... 69

3.8. Data Processing Procedure ... 69

3.8.1. Data Preparation... 69

3.8.2. Validity Test... 69

3.9. Data Analysis Technique ... 70

3.9.1. Summary Statistics... 70

3.9.2. Data Panel Summary... 71

3.9.3. Cross-Sectional Summary ... 71

CHAPTER 4 – RESULTS AND DISCUSSION ... 72

4.1. Descriptive Statistics (Summary Statistics) ... 72

4.2. Summary Statistics by Industry... 73

4.3. Data Panel Analysis ... 74

4.3.1. Dependent Variable: Analysis of Equal-Weighted Portfolio Returns ... 74

4.3.2. Independent Variable 1: MKT Portfolio ... 75

4.3.2.1. Data Panel Summary ... 75

4.3.2.2. Analysis of MKT Portfolio ... 80

4.3.3. Independent Variable 2: SMB Portfolio ... 80

4.3.3.2. Analysis of SMB Portfolio ... 80

4.3.4. Independent Variable 3: HML Portfolio ... 83

4.3.4.2. Analysis of HML Portfolio ... 84

4.4. Analysis of Fama and French Three-Factor Model ... 85

CHAPTER 5 – CONCLUSION AND RECOMMENDATION ... 88

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5.2. Recommendations ... 89

GLOSSARY ... 91

REFERENCES ... 92

APPENDICES ... 96

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Pandu Megananda LIST OF FIGURES

Figure Page

Figure 1: Frequency Distribution of Sample Based on Industry ...42

Figure 2: Long and Short Illustration...52

Figure 3: Obtaining 2016 SMB Portfolio Return ...65

Figure 4: Obtaining 2016 HML Portfolio Return ...68

Figure 5: Average Beta by Industry (2008 – 2013) ...79

Figure 6: Average Beta by Industry (2013 – 2018) ...79

Figure 7: Average CAPM Alpha by Industry (2008 – 2013) ...79

Figure 8: Average CAPM Alpha by Industry (2013 – 2018) ...79

Figure 9: SMB Portfolio Returns ...83

Figure 10: HML Portfolio Returns ...82

Figure 11: Summary of Results ...165

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Table Page

Table 1: Summary of Previous Studies ...37

Table 2: List of Companies with Special Events ...41

Table 3: Summary of Type of Data ...43

Table 4: Variable Operationalization ...44

Table 5: BCA’s Excess Returns ...53

Table 6: 2016 Portfolio Excess Deciles ...53

Table 7: Beta Periodicities ...55

Table 8: Historical Data of Market Return, Risk-Free Rate, Excess Return and Return of BBCA ...56

Table 9: Regression Results for Bank Central Asia ...56

Table 10: Bank Central Asia’s CAPM Alpha ...58

Table 11: 2016 MKT Portfolio Returns ...58

Table 12: BCA’s Share Outstanding and End of Year Price ...59

Table 13: Constructing 2016 SMB Portfolio ...62

Table 14: Calculating Historical Returns for BL Group ...64

Table 15: Market Capitalization and Total Equity for BCA ...67

Table 16: Summary Statistics for Descriptive Analysis ...72

Table 17: Variable Statistics by Industry ...73

Table 18: Portfolio Groupings and Portfolio Excess Return from 2008 – 2018 ...75

Table 19: Cross-Sectional Beta and Summary Statistics ...78

Table 20: Annual Average Beta and CAPM Alpha by Industry ...78

Table 21: Summary of Market Capitalization (Billions rupiahs) ...82

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Table 22: Number of Constituents, Portfolio Returns and SMB Portfolio Returns ...82

Table 23: Summary of BM Ratio...84

Table 24: Number of Constituents, Portfolio Returns and HML Portfolio Returns ...86

Table 25: Compiled Data for Three-Factor Model Regression ...87

Table 26: Regression Results ...87

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Pandu Megananda

Equation Page

Equation 2.1: Basic Structure of a Multi-Factor Model ...21

Equation 2.2: Single Index Model ...23

Equation 2.3: Covariance ...24

Equation 2.4: Capital Asset Pricing Model...25

Equation 2.5: Fama and French Three Factor Model ...27

Equation 2.6: Fama and French Four Factor Model ...33

Equation 3.1: Annualized Rate of Return (ARR) ...46

Equation 3.2: Holding Period Return (HPR) ...47

Equation 3.3: Holding Period Return with Dividend...48

Equation 3.4: One-Factor CAPM Regression ...54

Equation 3.5: Market Capitalization ...59

Equation 3.6: BM ...66

Equation 3.7: BM (Per Share Basis) ...66

Equation 3.8: BM (Per Share Basis) ...66