Fama And French Three Factor Model
The Fama and French Three-Factor Model is an asset pricing model developed in 1992 that expands on the capital asset pricing model (CAPM) by adding size risk and value risk factors to the market risk factor in CAPM. This model considers the fact that value and small-cap stocks outperform markets on a regular basis. By including these two additional factors, the model adjusts for this outperforming tendency, which is thought to make it a better tool for evaluating manager performance.
Fama-French Three-Factor Model
Definition
The Fama-French Three-Factor Model is an asset pricing model introduced in 1992 by Eugene Fama and Kenneth French. This model builds on the Capital Asset Pricing Model (CAPM) by adding two additional risk factors: size risk (SMB, Small Minus Big) and value risk (HML, High Minus Low). These factors aim to explain the phenomenon where small-cap stocks and value stocks often outperform the market.
Origin
Fama and French discovered in their 1992 study that the single-factor CAPM model could not fully explain the variations in stock returns. By analyzing extensive historical data, they proposed the Three-Factor Model to better capture the performance of different types of stocks in the market. The introduction of this model marked a significant development in asset pricing theory.
Categories and Characteristics
The Fama-French Three-Factor Model includes the following three factors:
- Market Risk Premium (MRP): The excess return of the market portfolio, similar to the market risk factor in CAPM.
- Size Risk Factor (SMB): The excess return of small-cap stocks over large-cap stocks. Research shows that small-cap stocks generally outperform large-cap stocks.
- Value Risk Factor (HML): The excess return of high book-to-market ratio stocks (value stocks) over low book-to-market ratio stocks (growth stocks). Value stocks generally outperform growth stocks.
Specific Cases
Case One: Suppose Investor A uses the CAPM model to evaluate the expected return of a small-cap value stock but finds that the actual return is much higher than expected. By introducing the Fama-French Three-Factor Model, Investor A can more accurately explain the high return of the stock, as the model accounts for the size and value risk factors.
Case Two: Fund Manager B manages a fund primarily composed of small-cap and value stocks. When evaluating the fund's performance using the CAPM model, the actual performance might be underestimated. By using the Fama-French Three-Factor Model, Fund Manager B can more comprehensively assess the fund's risk-adjusted returns, thereby more accurately measuring their management performance.
Common Questions
Question One: Is the Fama-French Three-Factor Model applicable to all markets?
Answer: The model is primarily based on data from the U.S. market. While it has some applicability in other markets, its effectiveness may not be as pronounced as in the U.S. market.
Question Two: Does the Three-Factor Model completely replace CAPM?
Answer: The Three-Factor Model does not completely replace CAPM but rather supplements and improves it. CAPM remains a foundational model, while the Three-Factor Model provides a more detailed risk assessment.
