Fama-French Three-Factor Model

Definition

The Fama-French Three-Factor Model is an asset pricing model that expands on the Capital Asset Pricing Model (CAPM) by incorporating three factors to explain stock returns: market risk, size, and value. This model highlights the size premium, indicating that smaller companies tend to outperform larger companies over time, while also factoring in the value premium, which suggests that stocks with lower prices relative to their fundamentals offer higher returns.

5 Must Know Facts For Your Next Test

1. The Fama-French Three-Factor Model was developed by Eugene Fama and Kenneth French in the early 1990s as a way to better explain stock returns than the CAPM.
2. The model includes three key factors: the market return, the size factor (SMB, or Small Minus Big), and the value factor (HML, or High Minus Low).
3. Research shows that small-cap stocks tend to generate higher average returns than large-cap stocks, which supports the concept of a size premium.
4. The model suggests that investors can earn excess returns by investing in portfolios with a high exposure to small-cap stocks and value stocks.
5. The Fama-French model has gained widespread acceptance among academics and practitioners due to its empirical performance in explaining variations in stock returns across different markets.

Review Questions

• How does the Fama-French Three-Factor Model improve upon the traditional Capital Asset Pricing Model in explaining stock returns?
  • The Fama-French Three-Factor Model improves upon the CAPM by introducing two additional factors: size and value. While CAPM considers only market risk through beta, the Fama-French model recognizes that smaller firms tend to yield higher returns due to their increased risk and that undervalued stocks also provide better long-term performance. By incorporating these factors, the model offers a more comprehensive explanation of why certain portfolios outperform others.
• Evaluate the significance of the size premium in the context of the Fama-French Three-Factor Model and its implications for investors.
  • The size premium is a critical element of the Fama-French Three-Factor Model, as it suggests that investing in smaller companies can lead to greater returns compared to larger firms. This is significant for investors because it indicates that portfolio diversification should include small-cap investments to potentially capture higher average returns. Understanding this premium helps investors make more informed decisions about asset allocation and risk management.
• Assess how both the size and value premiums in the Fama-French model contribute to portfolio management strategies in today's financial markets.
  • The size and value premiums identified in the Fama-French model are essential for portfolio management strategies because they guide investors toward identifying potentially higher-yielding investments. By incorporating small-cap and value stocks into their portfolios, investors can seek to exploit these premiums for better long-term performance. Additionally, understanding these factors allows fund managers to construct diversified portfolios that align with specific risk-return profiles, enhancing investment outcomes in varying market conditions.

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, represented by beta.

Size Premium: The additional return that investors expect to receive from investing in smaller companies compared to larger firms, reflecting the higher risk associated with small-cap stocks.

Value Premium: The tendency for stocks with low price-to-earnings ratios or low price-to-book ratios to outperform those with higher ratios, indicating a preference for undervalued stocks.