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Fama French

The document discusses the Fama-French three-factor model for estimating expected stock returns. It includes three factors - the market factor based on market index returns, a size factor based on small minus large cap stock returns, and a book-to-market factor based on high minus low B/M stock returns. Expected sector returns are estimated using the Fama-French model and compared to the CAPM model, with the Fama-French model producing higher expected returns for older industries like autos and construction and lower returns for newer industries like computers and pharmaceuticals. This difference is potentially because expected returns were initially higher for new industries that realized lower actual returns.

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Mahbub Hasan Yen
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42 views5 pages

Fama French

The document discusses the Fama-French three-factor model for estimating expected stock returns. It includes three factors - the market factor based on market index returns, a size factor based on small minus large cap stock returns, and a book-to-market factor based on high minus low B/M stock returns. Expected sector returns are estimated using the Fama-French model and compared to the CAPM model, with the Fama-French model producing higher expected returns for older industries like autos and construction and lower returns for newer industries like computers and pharmaceuticals. This difference is potentially because expected returns were initially higher for new industries that realized lower actual returns.

Uploaded by

Mahbub Hasan Yen
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PPTX, PDF, TXT or read online on Scribd
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Fama-French

Knut P. Heen PhD


Associate Professor
Molde University College
Three-Factor Model
Factors
Market factor
Return on market index minus risk-free rate
Size factor
Return on small-cap stocks minus return on large-cap stocks
Create small-cap portfolio → measure return on portfolio
Create large-cap portfolio → measure return on portfolio
Book-to-market factor
Return on high book-to-market ratio stocks minus return on low book-to-market
stocks
Create high B/M-portfolio → measure return on portfolio
Create low B/M-portfolio → measure return on portfolio

BØK705 Fama-French 9/12/2022 2


Risk Factor Premium
From Brealey, Myers, and Allen (2012)
1926-2008
Market risk premium = 7.0
Small minus large premium = 3.6
High minus low premium = 5.2
Updated info may be found on Kenneth French’s Dartmouth-website

Estimate the factor sensitivities (the betas)


Calculate expected returns

BØK705 Fama-French 9/12/2022 3


Expected Sector Returns
(Fama-French vs. CAPM)
Sector bmarket bsize bb/m E(R) FF E(R)CAPM
Autos 1,51 0,07 0,91 15,7 7,9
Banks 1,16 -0,25 0,72 11,1 6,2
Chemicals 1,02 -0,07 0,61 10,2 5,5
Computers 1,43 0,22 -0,87 6,5 12,8
Construction 1,40 0,46 0,98 16,6 7,6
Food 0,53 -0,15 0,47 5,8 2,7
Oil and gas 0,85 -0,13 0,54 8,5 4,3
Pharmaceuticals 0,50 -0,32 -0,13 1,9 4,3
Telecoms 1,05 -0,29 -0,16 5,7 7,3
Utilities 0,61 -0,01 0,77 8,4 2,4

BØK705 Fama-French 9/12/2022 4


Observations
Fama-French produces
Higher E(R) on old industries (autos, construction, chemicals)
Lower E(R) on new industries (computers, pharmaceuticals, telecom)

Economic intuition
Why are new industries relatively less risky than old industries?
Perhaps
Expected return of the new industries were high (old low)
Realized return of the new industries were low (old high)

BØK705 Fama-French 9/12/2022 5

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