Question

a. Fama and French (1993) developed a three-factor asset pricing model. What are the three risk factors in the Fama and French three-factor model? (1.5 marks)

b. What risks the three factors can capture?

c. What stocks are described as “value” and “growth” stocks under theoretical framework of Fama and French (1993)?

d. Carhart (1997) extended the Fama and French three-factor model to a four-factor model. What is the fourth factor added to the Fama and French three-factor model? What does the fourth factor account for? How is the fourth factor estimated?     

Answer 1

a. The three risk factors in the Fama and French three-factor model are: size of firms, book-to-market values and excess return on the market.

b. The three factors can capture market risk, bankruptcy risk, currency risk, supplier risk, etc. They create portfolios which capture the appropriate level of risk. Fama and French highlighted that investors would be able to ride out the extra short-term volatility and periodic underperformance that can occur in a short time.

c. Value stocks are stocks that has high book to market values and growth stocks are stocks that has low book to market value. The extra return of the value over growth stocks is because of the distress risk inherited with them.

d. The fourth factor added to the Fama and French three-factor model is the momentum factor. It is accounted for the tendency of stock price to continue rising if it is going up and to continue declining if it is going down. The MOM is estimated by subtracting the equal weighted average of the lowest performing firms from the equal weighed average of the highest performing firms, lagging one month.