Test of the Fama-French three-factor model in Crotia

This paper empirically examines the Fama-French three-factor model of stock returns for Croatia. In contrast to the results of Fama and French (1993) for the U.S. stock market, their three-factor model did not show so successful when describing risk-return relation of Croatian stocks. This paper shows that the Fama-French three-factor model is a valid pricing model, since it explains cross-section of average returns on stocks in Croatia, and that has a greater explanatory power in comparison to the CAPM. In the case of Croatian stock market, size and B/M factors are not always significant, but on average they individually have certain marginal explanatory power. Namely, they capture small common variation in returns that is missed by the market factor. Moreover, B/M factor has shown as a stronger common risk proxy in relation to size factor. Finally, there is still a large portion of common variation in stock return that may be explained by other factors. Because emerging capital markets bear their own specificity, special care needs to be taken when applying existing or developing new pricing models.