Question

Explain the CAPM and Fama-French 3-factor. Discuss the differences between these two models.

Answer 1

Answer-

Capital Asset Pricing Model (CAPM)  

Required return on equity = risk free rate + beta x ( market return - risk free rate)

OR

Required return on equity = risk free rate + ( beta x equity risk premium).

beta is the risk measure.

Fama- French 3 factor model

It is a multifactor model that proposes the account for the higher returns generally associated with small capitalization stocks.

reqired return for stock = risk free rate + Beta mkt  ( R mkt - risk free rate ) + Beta smb ( R small - R big ) + Beta hml x ( R hmb - R lmb)

( R mkt - risk free rate ) = return on a value weigthed market index minus the risk free rate

( R small - R big ) = a small cap return premium equal to average reurn on small cap portfolios minus average return on large cap portfolios

( R hmb - R lmb) = a value return premium that is equal to averagereturn on book to mafrket portfolios minus the average return on low book to market return portfolios.

The differences between CAPM and Fama-French 3 factor model are

1) CAPM is a single factor model whereas Fama-French 3 factor model is a multi factor model
2) CAPM is simple to use whereas Fama-French 3 factor model is complex
3) CAPM is having low explanatory power whereas Fama- French 3 factor model has a greater explanatory model.