Fama-French

Definition

The Fama-French model is a widely-used asset pricing model that expands on the Capital Asset Pricing Model (CAPM) by adding factors to better explain stock returns. It includes three key factors: market risk, size, and value, indicating that smaller companies and those with higher book-to-market ratios tend to outperform larger companies. This model offers a more nuanced understanding of expected returns by considering additional dimensions beyond just market risk.

5 Must Know Facts For Your Next Test

1. The Fama-French three-factor model was introduced by Eugene Fama and Kenneth French in their 1993 paper, which expanded upon CAPM.
2. The three factors in the model are the market return, the size factor (SMB - Small Minus Big), and the value factor (HML - High Minus Low).
3. Fama and French later expanded their model to include a fourth factor, profitability, and a fifth factor, investment, creating the five-factor model.
4. The model helps investors understand why certain stocks tend to outperform others over time, emphasizing the importance of both size and value in portfolio construction.
5. Empirical tests have shown that the Fama-French model provides better explanatory power for stock returns compared to the CAPM alone.

Review Questions

• How does the Fama-French model improve upon the traditional Capital Asset Pricing Model in explaining stock returns?
  • The Fama-French model improves upon CAPM by incorporating additional factors beyond market risk. While CAPM considers only systematic risk through beta, the Fama-French model adds size and value factors, recognizing that smaller companies and those with high book-to-market ratios generally yield higher returns. This broader approach offers investors a more comprehensive understanding of expected returns, leading to better asset pricing and investment decisions.
• Discuss the significance of the size and value factors in the Fama-French model and how they influence investor behavior.
  • The size and value factors in the Fama-French model highlight critical patterns in stock performance. The size effect indicates that smaller companies typically outperform larger ones over time, while the value effect suggests that stocks with high book-to-market ratios are often undervalued and may deliver higher returns. This understanding influences investor behavior by encouraging them to allocate funds toward small-cap and value stocks as part of a diversified investment strategy aimed at maximizing returns.
• Evaluate the impact of the Fama-French five-factor model on modern portfolio management practices.
  • The introduction of the Fama-French five-factor model has significantly influenced modern portfolio management by providing a more detailed framework for analyzing expected returns. By incorporating factors such as profitability and investment alongside size and value, portfolio managers can make more informed decisions about asset allocation and risk management. This model helps identify investment opportunities that align with specific risk profiles, ultimately enhancing performance while considering multiple dimensions of risk in their strategies.

Related terms

Capital Asset Pricing Model (CAPM): A model that establishes a linear relationship between the expected return of an asset and its systematic risk, often used to determine the cost of equity.

Size Effect: The phenomenon where smaller firms tend to have higher risk-adjusted returns than larger firms, influencing investment strategies and portfolio management.

Value Investing: An investment strategy that involves selecting stocks that appear to be undervalued based on fundamental analysis, often using metrics like book-to-market ratio.