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Fama and French Model

The Capital Asset Pricing Model (CAPM) establishes a linear relationship between an asset's expected return and its systematic risk, utilizing factors such as beta and the risk-free rate. The Fama-French three-factor model extends CAPM by incorporating market risk, small-cap outperformance, and high book-to-market value outperformance to better explain stock returns. This model provides insights into risk and return dynamics, helping investors understand market efficiency and evaluate performance.

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13 views10 pages

Fama and French Model

The Capital Asset Pricing Model (CAPM) establishes a linear relationship between an asset's expected return and its systematic risk, utilizing factors such as beta and the risk-free rate. The Fama-French three-factor model extends CAPM by incorporating market risk, small-cap outperformance, and high book-to-market value outperformance to better explain stock returns. This model provides insights into risk and return dynamics, helping investors understand market efficiency and evaluate performance.

Uploaded by

ipm04harshk
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Fama and French Model

Sunil Gangwani
Capital Asset Pricing Model
What Is the Capital Asset Pricing Model (CAPM)?
The capital asset pricing model (CAPM) describes the relationship between
systematic risk, or the general perils of investing, and expected return for assets,
particularly stocks. It is a finance model that establishes a linear relationship
between the required return on an investment and risk.

● CAPM is based on the relationship between an asset’s beta, the risk-free rate
(typically the Treasury bill rate), and the equity risk premium, or the expected
return on the market minus the risk-free rate.

● CAPM evolved as a way to measure this systematic risk. It is widely used


throughout finance for pricing risky securities and generating expected returns
for assets, given the risk of those assets and cost of capital.
CAPM formula
Capital Asset Pricing Model (CAPM) Formula
The formula for calculating the expected return of an asset, given its risk, is as follows:

ERi=Rf+βi(ERm−Rf)

where:ERi=expected return of investment

Rf=risk-free rate

βi=beta of the investment

(ERm−Rf)=market risk premium


Fama and French model

The Fama-French three-factor model is a statistical model that describes stock returns by considering
three factors:
1. Market risk
2. Outperformance of small-cap companies,
3. and Outperformance of high book-to-market value companies.

The model was developed in 1992 by Nobel laureates Eugene Fama and Kenneth French, who were
colleagues at the University of Chicago Booth School of Business. It's an extension of the Capital Asset
Pricing Model (CAPM) and is based on an econometric regression of historical stock prices.
Key features
The Fama-French model is used to:

● Explain a larger fraction of long-term expected return variations


● Adjust for the tendency of small-cap and value stocks to outperform markets
● Evaluate manager performance
● Provide a more comprehensive understanding of risk and return dynamics in financial markets
● See how exposed you are to the market, size, and value factors
Fama and French Model
The model is expressed as:
Return = Rf + Ri + SMB + HML
Where
Return: is the rate of return on your portfolio or investment being measured
Rf: is the risk-free rate
Ri: is the market risk premium
SMB (or Small Minus Big): is the performance of small-cap companies vs. large-cap companies
HML (or High Minus Low): is the performance of high book-to-market (or “value”) stocks vs. low book-to-
market (or “growth”) stocks
Market Efficiency/ inefficiency
There is a lot of debate about whether the outperformance tendency is due to
market efficiency or market inefficiency.
● In support of market efficiency, the outperformance is generally explained by
the excess risk that value and small-cap stocks face as a result of their higher
cost of capital and greater business risk.
● In support of market inefficiency, the outperformance is explained by market
participants incorrectly pricing the value of these companies, which provides
the excess return in the long run as the value adjusts. Investors who
subscribe to the body of evidence provided by the Efficient Markets
Hypothesis (EMH) are more likely to agree with the efficiency side.
Simplified version
FAMA and French model
The Fama-French Three-Factor Model Formula

Where:

● r = Expected rate of return


● rf = Risk-free rate
● ß = Factor’s coefficient (sensitivity)
● (rm – rf) = Market risk premium
● SMB (Small Minus Big) = Historic excess returns of small-cap companies over large-cap
companies
● HML (High Minus Low) = Historic excess returns of value stocks (high book-to-price ratio) over
growth stocks (low book-to-price ratio)
● ↋ = Risk
Reasoning
Fama and French highlighted that investors must be able to ride out the extra volatility and periodic
underperformance that could occur in a short time.

Investors with a long-term time horizon of 15 years or more will be rewarded for losses suffered in the short
term.

Using thousands of random stock portfolios, Fama and French conducted studies to test their model and found
that when size and value factors are combined with the beta factor, they could then explain as much as 95% of
the return in a diversified stock portfolio.

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