Risk premiums over varying market conditions

Abstract

Bhardwaj and Brooks (1993) and Kim and Burnie (2002) look at the size effect during expansion and recession but come to different conclusions. While Bhardwaj and Brooks report reversal of size effects, Kim and Burnie show that the size effect is strong during economic expansion. A possible reason for these conflicting conclusions might be model misspecification. Both studies use a single-factor CAPM model to calculate the average returns. In this paper, the Fama-French three-factor model with betas conditioned on the market states is used. It has been found that the reverse size effect is limited to growth stocks. The size effect among value stocks is observed in expansion as well as recession. Furthermore, regression results using the three-factor model with time-varying betas show that there is a negative book-to-market premium.