This study tests the validity of the Fama and French three-factor asset pricing model on the Istanbul Stock Exchange (ISE). Monthly excess stock returns over the period from 2003 to 2010 are used in the analysis. Realized returns show that portfolios containing large firms have higher average excess returns than portfolios containing smaller sized firms. Generally, portfolios containing low book-to-market ratio firms perform better than those containing high book-to-market ratio firms. Nine portfolios are constructed according to size and book-to-market ratio of firms in order to explain the variations on excess portfolio returns by using market risk factor, size risk factor and book-to-market ratio risk factors. Size factor has no effect on portfolios having big-size firms but can explain the excess return variations on portfolios having small and medium-sized firms. Book-to-market ratio factor has an effect on portfolios with high book-to-market ratio firms. Fama and French three-factor model has power on explaining variations on excess portfolio returns but this power is not strong throughout the test period on the ISE.

Keywords:Asset pricing, book-to-market ratio, Fama and French three factor model, risk, excess return.