APPLICABILITY OF THE FAMA-FRENCH THREE-FACTOR MODEL IN FORECASTING PORTFOLIO RETURNS

For the model-based estimation of the equity cost of capital, evidence shows that the common practice of using the average historical factor premiums as the estimates of the next-period factor premiums generates inaccurate estimates. I propose an alternative way to estimate factor premiums by using the structural variables that are important predictors of future asset returns. Based on the out-of-sample results from a trading strategy with four in-sample model-selection criteria, I find that my estimation procedure performs better than the common practice even when transaction costs are considered. 2007 The Southern Finance Association and the Southwestern Finance Association.