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 incorporating three factors: market risk, size, and value. This model helps explain stock returns by recognizing that smaller companies and those with high book-to-market ratios tend to outperform larger companies and those with lower book-to-market ratios. By adding these factors, it addresses some anomalies in market efficiency observed in real-world data.

5 Must Know Facts For Your Next Test

1. The Fama-French model was developed by Eugene Fama and Kenneth French in the early 1990s as a response to observed patterns in stock returns that CAPM could not explain.
2. The three factors in the model are: the market return minus the risk-free rate, the size effect (small minus big), and the value effect (high minus low book-to-market ratios).
3. The model suggests that smaller companies tend to have higher returns than larger companies, a phenomenon known as the size effect.
4. The value effect posits that stocks with high book-to-market ratios outperform those with low ratios, challenging the efficient market hypothesis.
5. This model has been widely adopted in finance for portfolio management and performance evaluation, providing insights into the behavior of asset prices beyond traditional risk-return relationships.

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 (CAPM) by adding two additional factors—size and value—alongside market risk. CAPM only considers the relationship between an asset's expected return and its systematic risk through beta. In contrast, the Fama-French model recognizes that smaller companies and those with higher book-to-market ratios consistently outperform larger firms, thus providing a more comprehensive explanation of stock return anomalies.
• Discuss the implications of the Fama-French model for investors looking to capitalize on market inefficiencies.
  • The implications of the Fama-French model suggest that investors can exploit market inefficiencies by focusing on smaller companies and value stocks, as these tend to offer higher expected returns compared to their larger or growth counterparts. This challenges the notion of complete market efficiency, as it highlights systematic patterns that savvy investors can leverage for better portfolio performance. By understanding these factors, investors can make more informed decisions about asset allocation.
• Evaluate how the Fama-French Three-Factor Model has influenced modern finance and investment strategies.
  • The Fama-French Three-Factor Model has profoundly influenced modern finance by reshaping investment strategies and portfolio management techniques. It introduced a more nuanced approach to understanding stock returns, leading to greater emphasis on factor investing strategies that consider size and value alongside traditional market risk. As a result, investment funds and advisors now utilize these insights to create diversified portfolios aimed at capturing excess returns linked to these factors, thus redefining benchmarks for evaluating performance.

Related terms

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

Market Efficiency:

The hypothesis that asset prices fully reflect all available information at any point in time, making it impossible to consistently achieve higher returns without taking on additional risk.

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