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Explanations for the Factors in the Fama-French Model

In: Business and Management

Submitted By wiau2007
Words 3787
Pages 16
The Fama and French 3-Factor Model (Fama and French 1993) is used in asset pricing and portfolio management to describe stock returns. Unlike the CAPM, which uses only the market risk factor, in the Fama and French Model, two more factors are identified that cause stocks to do better than the market as a whole – the size factor and the value factor. This paper will first describe the methodology behind the size and value factor calculations. We will then discuss possible explanations as to why the two factors explain stock returns. Finally, we determine on the basis of academic evidence whether the two factors capture systematic risk.
The three-factor model is mathematically expressed as follows:

Where:
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r = portfolio expected return
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Β3 = “three factor” beta (conceptually analogous to the CAPM beta but not equal to it due to the presence of the two other coefficients in the regression)
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(Km- Rf) = market risk premium
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bs = sensitivity of expected return to size factor
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SMB = Small (market capitalisation) minus big
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bv = sensitivity of expected return to value factor
HML = high (book to market ratio) minus low
Fama and French (1992a) found that the historical-average returns on stocks with small market capitalisations and higher book-to-market ratios are higher than what the security market line would predict (Bodie, Kane and Marcus 2014). They assumed that any factors which corresponded to higher or lower returns consistently are indicators of a source of systematic risk and hence included the size premium (SMB) and value premium (HML) in their model along...

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