S:\MCFS\Academic Research Grants\Academic Research Grants 1_2006\Working Papers\Dempsey The book-to-Market Equity ratio.doc1 The Book-to-Market Equity Ratio as a Proxy for Risk: Evidence from Australian Markets

Crucial to the interpretation of the Fama and French three-factor model, is the question of whether the book-to-market equity ratio should be assigned as a “risk-based, ” as opposed to a “mispricing ” explanation of share price formation. In the context of Australian stock markets, we examine the role of the book-to-market equity ratio in the formation of stock returns. Notwithstanding the distinctive characteristics of Australian markets, our findings are complementary with findings for U.S. stocks. We succeed in revealing a strong association between stock returns and the firm’s book-to-market equity ratio, and find strong evidence that the association derives from the book-to-market ratio’s absorption of the implications of firm leverage as a risk factor