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 including three factors: market risk, size, and value. This model aims to explain stock returns better by considering the risk associated with small-cap stocks and high book-to-market value stocks, thus addressing some limitations of the traditional CAPM in capturing the variations in asset returns.

5 Must Know Facts For Your Next Test

1. The three factors in the Fama-French model are: the excess return of the market over the risk-free rate, the size premium that accounts for the outperformance of small-cap stocks, and the value premium that reflects the tendency for high book-to-market stocks to outperform growth stocks.
2. The Fama-French model is widely used in empirical finance as it has been shown to explain stock returns more accurately than CAPM alone.
3. In this model, the size premium is based on the idea that smaller companies have higher risk and thus should yield higher returns over time compared to larger companies.
4. The value premium suggests that companies with high book-to-market ratios tend to outperform those with lower ratios, a phenomenon observed in historical data.
5. Fama and French introduced this model in their 1993 paper, demonstrating its effectiveness through rigorous statistical analysis of stock returns.

Review Questions

• How does the Fama-French Three-Factor Model improve upon the Capital Asset Pricing Model (CAPM) in explaining stock returns?
  • The Fama-French Three-Factor Model improves on CAPM by incorporating two additional factors: size and value, alongside market risk. While CAPM focuses solely on systematic risk represented by beta, the three-factor model recognizes that smaller firms tend to outperform larger firms and that high book-to-market value firms typically have higher returns than growth stocks. This broader perspective allows for a more comprehensive understanding of asset returns across different market conditions.
• Discuss the significance of small-cap and value stocks in the context of the Fama-French Three-Factor Model and their implications for investors.
  • In the Fama-French Three-Factor Model, small-cap and value stocks are significant because they highlight patterns in stock performance that traditional models overlook. The inclusion of these factors suggests that investors should consider size and book-to-market ratios when constructing portfolios. Small-cap stocks generally offer higher potential returns due to their associated risks, while value stocks may provide opportunities for undervalued investments. This insight helps investors make informed decisions based on historical trends rather than relying solely on broader market behavior.
• Evaluate how well the Fama-French Three-Factor Model has stood up to empirical testing in financial markets since its introduction.
  • Since its introduction, empirical testing has generally supported the validity of the Fama-French Three-Factor Model, demonstrating its effectiveness in explaining variations in stock returns across different market segments. Researchers have found that both size and value premiums hold across various time periods and markets, although some argue that these factors can be time-sensitive or influenced by market conditions. Overall, while it has limitations like any model, its empirical success has made it a cornerstone in financial literature and investment strategy development.

Related terms

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

Small-cap stocks: Stocks of smaller companies, typically with a market capitalization of under $2 billion, which are often seen as riskier investments but may offer higher potential returns.

Book-to-market ratio: A financial valuation metric used to compare a company's book value to its market value, often indicating whether a stock is undervalued or overvalued.