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 adding two additional factors to better explain stock returns: size and value. This model suggests that smaller companies and those with higher book-to-market ratios (value stocks) tend to outperform the market, offering a more comprehensive understanding of expected returns than CAPM, which only considers market risk.

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 response to the limitations of CAPM.
2. The three factors in this model are the market return, the size premium (SMB), and the value premium (HML), which together help explain variations in stock returns.
3. The addition of size and value factors allows the model to better account for the empirical observation that small-cap and value stocks tend to outperform large-cap and growth stocks over time.
4. The SMB (Small Minus Big) factor captures the performance difference between small-cap and large-cap stocks, while HML (High Minus Low) reflects the difference between high book-to-market (value) and low book-to-market (growth) stocks.
5. The Fama-French three-factor model is widely used by portfolio managers and researchers to evaluate stock performance and to construct investment portfolios based on risk factors.

Review Questions

• How does the Fama-French three-factor model improve upon the Capital Asset Pricing Model in explaining stock returns?
  • The Fama-French three-factor model improves upon the Capital Asset Pricing Model by introducing two additional factors: size and value, alongside market risk. While CAPM considers only the market return as a determinant of expected returns, the Fama-French model accounts for empirical evidence showing that smaller companies and value stocks typically yield higher returns. By incorporating these factors, the three-factor model provides a more nuanced understanding of stock performance, making it a more effective tool for investors.
• Discuss the implications of size and value factors in investment strategy according to the Fama-French three-factor model.
  • According to the Fama-French three-factor model, the implications of size and value factors suggest that investors may achieve higher expected returns by focusing on small-cap stocks and those with high book-to-market ratios. The size premium indicates that smaller firms are often riskier but provide greater potential rewards, while the value premium highlights how undervalued companies can outperform overvalued growth companies. These insights encourage investors to incorporate these factors into their strategies for better portfolio performance.
• Evaluate how the Fama-French three-factor model has influenced modern asset pricing theories and investment practices.
  • The Fama-French three-factor model has significantly influenced modern asset pricing theories by challenging traditional views represented by CAPM. Its introduction of additional factors has prompted researchers and practitioners to reconsider how risk is evaluated and how expected returns are determined. As a result, this model has led to more sophisticated asset allocation strategies that account for various dimensions of risk beyond market exposure. Moreover, it has paved the way for further research into multi-factor models, enhancing our understanding of asset pricing in financial markets.

Related terms

Capital Asset Pricing Model (CAPM): A financial model that establishes a linear relationship between the expected return of an asset and its systematic risk, measured by beta.

Size Premium: The additional return that investors expect to earn from investing in smaller-cap stocks compared to larger-cap stocks, often due to their higher perceived risk.

Value Investing: An investment strategy that involves picking stocks that appear to be trading for less than their intrinsic or book value, typically focusing on high book-to-market ratios.