Question

What are the strategic implications for portfolio construction using the three factor Fama-French model?

Answer 1

The strategic implications for portfolio construction by using the three factor Fama-French model for estimating future returns. It includes risk-free return, the market beta, size premium, value premium, alpha and random error

Following is the equation of Fama-French 3 factor model

R –Rf = α + βm * [E(Rm) – Rf] + βsmb * E(Rsmb) + βhml * E (Rhml) + ei

Where,

R is the expected rate of return of Stock

Rf is the risk-free return rate

E (Rm) is the return of the market portfolio

Market beta, βm

Impact of active management, α

E (Rsmb) is expected return of SMB

SMB beta, βsmb

E (Rhml) is expected return of HML

HML beta, βhml

Where, Size of firm for size premium: SMB (small minus big); the small market caps that generate higher returns than the large cap stocks

Book-to-market values for value premium: HML (high minus low); the value stocks with high book-to-market ratios that generate higher returns than the market