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Empirical Test of Fama French Three Factor Model and Illiquidity Premium in Indonesia

This study explores Fama French Three Factor Model and illiquidity premium in Indonesia. The objective of this research is to find evidence about the effect from market beta, size, value, and liquidity to the stock excess return in Indonesia. We use Amihud (2002) illiquidity as a proxy for illiquidity. This study uses Ordinary Least Squares (OLS) regression with monthly time series data over 10 years, from 2003 to 2013, and use dummy variable to make difference in crisis period and non-crisis period. We devided the portfolios into 12 portfolios, sorted by size-illiquidity and book-to-market (BM)-illiquidity. The results showed that market beta (excess market return) consistently positive and significant in each portfolio, when sorted by both criterion. Size factor (SMB) has explanatory power to explain illiquidity factor (ILLIQ) and vice versa. We also find that stocks with small size outperformed stocks with big size. HML coefficient increases when the book-to-market increased, whereas the SMB coefficient increases when liquidity decreases. This could be an indication that the small stock is more difficult to be traded (illiquid). The values of adjusted R2 are in the range of 0.58-0.88, it means that the value is quite big and the model can be used (applicable) on the stock market in Indonesia. Overall, we conclude that there are market risk premium, size premium, value premium and illiquidity risk premium which can explain the excess return in Indonesia. Subprime mortgage crisis statistically has no effect in all portfolios. The results supported Fama and French (1992, 1993) and the results of Lam and Tam (2011).