Question

When the result of beta market and beta smb and beta hml more than 1 , what does it indicate? When it will become significant ? Is it good if its less than 2 or more than 2 ? Explain

Answer 1

The intepretation of these three factors from the FAMA/French model for the expected rate of return of a stock is:

• b (market risk premium) = this coefficient measures how sensitive is the stock of the particular company in relation to the market return premium. The beta of the market is always 1, so the stock´s beta is compared to the market´s one by measuring its deviation. Thus, whenever the stock beta is higher than 1, it will mean that the stock is more volatile than the market. In this sense, it is better that the stock beta be less than 2 whenever our objective is to reduce the risk and have more certainty as to how will our stock behave vs. the market. However, if our objective is to play risky, with a stock which beta is 2 or more, we could expect way higher returns whenever the market conditions are favorable.
• b smb (small minus big) = this coefficient measures how sensitive is the stock in relation to the extra returns of the companies with small market capitalization over those that have a big capitalization. Whenever the beta is positive, on average it will mean that the stock favors the stock of the companies with small cap (there are studies that prove that this does not always hold true, though). So, in this case, if it is higher than 2, the return on the stock will be more than positively exposed to the factor.
• b hml (high minus low) = the coefficient measures the sensitivity of the stock as related to the difference in returns between companies with high book-to-market equity ratio and those with low book-to-market equity ratio. The higher the coefficient , the higher the certainty that the company´s return is due to its high book-to-market equity ratio.