FAMA & French Model Flashcards
(12 cards)
What is the Fama-French Three-Factor Model?
A model developed by Eugene Fama and Kenneth French that explains stock returns using three factors: market risk, company size, and book-to-market value.
How does the Fama-French model improve upon CAPM?
It includes two additional factors—SMB (Small minus big: return spread between small-cap and large-cap stocks) and HML (High Minus Low: return spread between high and low book-to-market (value vs. growth)—to capture size and value effects, which CAPM misses.
What is the formula for the Fama-French Three-Factor Model?
r = Rf + β3(Km −Rf) + bs ∗ SMB + bv ∗ HML + α
What is SMB in the Fama-French model?
“Small Minus Big” – the return difference between small-cap and large-cap stock portfolios, measuring the size premium.
What is HML in the Fama-French model?
“High Minus Low” – the return difference between high and low book-to-market stocks, measuring the value premium.
Why are small-cap and value stocks included in the model?
Historically, they have outperformed the market, indicating additional sources of risk and return not captured by CAPM.
What does
𝛼
α represent in the Fama-French model?
The abnormal return (alpha) not explained by the three factors.
What is a key limitation of the Fama-French model?
Its effectiveness depends on accurate empirical testing; the factors may not always predict returns consistently in different markets or time periods.
What is 𝛽m in the Fama-French equation?
CAPM Beta
What does 𝛽s represent in the Fama-French model?
β
s
is the sensitivity of the asset’s return to the SMB factor (Small Minus Big). It shows how much the return is affected by size-related risk.
What does 𝛽𝑣 represent in the Fama-French model?
the sensitivity of the asset’s return to the HML factor (High Minus Low), capturing exposure to value risk.
How do 𝛽𝑠 and 𝛽𝑣 contribute to portfolio returns?
They measure how exposed a portfolio is to the size and value risk factors, which can lead to higher or lower returns depending on market conditions.
