Analyzing impact of trading cost on Fama French and momentum factor (Four Factor Model)

Abstract

Fama French three factor model and momentum factor explains the stock returns using, outperformance of small cap stock against big cap stocks, outperformance of high B/M stocks against low B/M value stocks and effect of momentum in equity market. The Fama French model fails to take into account the impact of transaction cost on these factor returns. Also, Fama French model assumes continuous portfolio rebalancing and no restriction on the short portfolios. But, in practice trading costs significantly impacts the return from stock. Also investors cannot take a short position on a stock except in for intraday trading. Thus, various trading strategies like long-short portfolios are not feasible in Indian equity market. Also, liquidity of the stock impacts the trading cost significantly. Thus, in this study we have decided to compute the returns that can be generated in Indian Equity Market using Fama French factors and momentum factor after considering transaction cost and with minimum and practical assumptions.