Question

Compare and contrast CAPM and Fama French three factor model.  How three factor model of Fama and French addresses the limitations of CAPM Model? Additionally, what are shortcomings of the three factor models and how can addressed?

Answer 1

Capital Asset pricing model is used to find expected rate of return after the consideration of market risk in form of systematic risk which is represented by the beta whereas fama French three factor model is an expansion of Capital Asset pricing model which will be including to other Factors along with market risk like size risk and value risk factors.

applicability of capital asset pricing model is way ahead and applicability of French farmer model because fama French three factor model is complex valuation model and which is not easily applicable to the valuation of securities in order to find the expected rate of return.

Three factor model will be addressing the limitation of Capital Asset pricing model bye by adding two other Factors along with market risk like size factor in which it is advocating the small versus The large companies and then finding the expected rate of return and it is also comparing the book value to the market value of the company in order to find out the expected rate of return after finding out whether the company is overvalued or undervalued according to the comparison of intrinsic value to the market price.

fama French three factor model is a complex model which will not be including the macro factors into overall valuation and it is not easy to calculate and it is also not representing the interrelationship of all three factors upon each other so this French fama three factor model is a smaller implication in the entire valuation of finding the rate of return.