Fama-French Three-Factor Model
Fama-French Three-Factor Model
Capital Marketing
Shijie Wu
Fama-French Three-Factor Asset Pricing Model
I. Definition of Fama-French Three-Factor Model
A. Definition
In asset pricing and portfolio management, the Fama-French three-factor model is a theory that improvement of the capital asset pricing model. The model is proposed based on the empirical study of historical returns as a result of U.S. stock market. The purpose is to explain the average returns of the stock market that is affected by which the risk premium factors.
B. Equation
Under the capital asset pricing model, all the risk premium of investment portfolio express by the Beta coefficient, but cannot use this model to explain the present situation of the stock market returns.
After Fama-French researched, they demonstrates only beta cannot fully explain the stock market return, but plus the scale factors and value factors can better explain on the stock market return. Fama-French come up with the three factors model that contains the market factor, value factors, and scale factors.
Here r is the portfolio's expected rate of return, Rf is the risk-free return rate, and Km is the return of the market portfolio. The "three factor" β is analogous to the classical β but not equal to it, since there are now two additional factors to do some of the work. SMB stands for "Small [market capitalization] Minus Big” and HML for "High [book-to-market ratio] Minus Low"; they measure the historic excess returns of small caps over big caps and of value stocks over growth stocks. These factors are calculated with combinations of portfolios composed by ranked stocks and available historical market data.
II. Asset Pricing Models
A. Capital Asset Pricing Market Model
The Capital Asset Pricing Model is the first model in asset pricing. It is the most widely used model because of its simplicity. It assumes that investors respect the Markowitz mean-variance criterion in
Capital Marketing
Shijie Wu
Fama-French Three-Factor Asset Pricing Model
I. Definition of Fama-French Three-Factor Model
A. Definition
In asset pricing and portfolio management, the Fama-French three-factor model is a theory that improvement of the capital asset pricing model. The model is proposed based on the empirical study of historical returns as a result of U.S. stock market. The purpose is to explain the average returns of the stock market that is affected by which the risk premium factors.
B. Equation
Under the capital asset pricing model, all the risk premium of investment portfolio express by the Beta coefficient, but cannot use this model to explain the present situation of the stock market returns.
After Fama-French researched, they demonstrates only beta cannot fully explain the stock market return, but plus the scale factors and value factors can better explain on the stock market return. Fama-French come up with the three factors model that contains the market factor, value factors, and scale factors.
Here r is the portfolio's expected rate of return, Rf is the risk-free return rate, and Km is the return of the market portfolio. The "three factor" β is analogous to the classical β but not equal to it, since there are now two additional factors to do some of the work. SMB stands for "Small [market capitalization] Minus Big” and HML for "High [book-to-market ratio] Minus Low"; they measure the historic excess returns of small caps over big caps and of value stocks over growth stocks. These factors are calculated with combinations of portfolios composed by ranked stocks and available historical market data.
II. Asset Pricing Models
A. Capital Asset Pricing Market Model
The Capital Asset Pricing Model is the first model in asset pricing. It is the most widely used model because of its simplicity. It assumes that investors respect the Markowitz mean-variance criterion in