Present the three-factors CAPM model and discuss how it tackles the limitations of the one-factor model.

Present the three-factors CAPM model and discuss how it tackles the limitations of the one-factor model.

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Answer-

The Fama-French model is a three factor model which is an extension of CAPM model.

The Fama-French model aims to describe stock returns through three factors:

1) market risk,
2) the small-cap companies outperforming the large-cap companies, and
3) the high book-to-market value companies outperforming low book-to-market value companies.
The rationale behind the model is that high value and small-cap companies tend to regularly outperform the overall market.

The CAPM model which is a onefactor model that has the drawbaks that are listed below:

This model includes the Beta in the formula, we are assuming that the risk can be completely measured by a stock’s price volatility, however moving the price in two different directions is not equally risky.

CAPM also assumes that the Risk-free rate which stays the same during the period of discounting.

The other drawback regarding CAPM is that future cash flows can be estimated for the process of discounting.

All the above factors are nullified in the Fama French model. The model is adjusted for outperformance tendencies and two extra risk factors make the model more flexible relative to CAPM.

jeff jeffy answered 1 year ago

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