Question

In: Finance

Question 2 Briefly explain the Fama and French (1996) three-factor model. [14 marks]

Question 2 Briefly explain the Fama and French (1996) three-factor model. [14 marks]

Solutions

Expert Solution

Ans ) Fama and French three factors model

The Fama and French Three-Factor Model (or the Fama French Model for short) is an asset pricing model developed in 1992 that expands on the capital asset pricing model (CAPM) by adding size risk and value risk factors to the market risk factor in CAPM. This model considers the fact that value and small-cap stocks outperform markets on a regular basis. By including these two additional factors, the model adjusts for this outperforming tendency, which is thought to make it a better tool for evaluating manager performance

The Formula for the Fama French Model Is:

=total return of a stock or portfolio i at time tRft​=risk free rate of return at time tRMt​=total market portfolio return at time tRit​−Rft​=expected excess returnRMt​−Rft​=excess return on the market portfolio (index)SMBt​=size premium (small minus big)HMLt​=value premium (high minus low)β1,2,3​=factor coefficients​

How the Fama French Model Works

Nobel Laureate Eugene Fama and researcher Kenneth French, former professors at the University of Chicago Booth School of Business, attempted to better measure market returns and, through research, found that value stocks outperform growth stocks. Similarly, small-cap stocks tend to outperform large-cap stocks. As an evaluation tool, the performance of portfolios with a large number of small-cap or value stocks would be lower than the CAPM result, as the Three-Factor Model adjusts downward for observed small-cap and value stock out-performance.

The Fama and French model has three factors: size of firms, book-to-market values and excess return on the market. In other words, the three factors used are SMB (small minus big), HML (high minus low) and the portfolio's return less the risk free rate of return. SMB accounts for publicly traded companies with small market caps that generate higher returns, while HML accounts for value stocks with high book-to-market ratios that generate higher returns in comparison to the market.

There is a lot of debate about whether the outperformance tendency is due to market efficiency or market inefficiency. In support of market efficiency, the outperformance is generally explained by the excess risk that value and small-cap stocks face as a result of their higher cost of capital and greater business risk. In support of market inefficiency, the outperformance is explained by market participants incorrectly pricing the value of these companies, which provides the excess return in the long run as the value adjusts. Investors who subscribe to the body of evidence provided by the Efficient Markets Hypothesis (EMH) are more likely to agree with the efficiency side.


Related Solutions

1.Explain the Two-Factor model by Merton. 2.Explain the Fama-French Three-Factor Model.
1.Explain the Two-Factor model by Merton. 2.Explain the Fama-French Three-Factor Model.
Compare and contrast CAPM and Fama French three factor model.  How three factor model of Fama and...
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?
What criticisms could be made of the Fama and French three factor model.
What criticisms could be made of the Fama and French three factor model.
a. Fama and French (1993) developed a three-factor asset pricing model. What are the three risk...
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...
An analyst has modeled the stock of a company using the Fama-French three-factor model. The market...
An analyst has modeled the stock of a company using the Fama-French three-factor model. The market return is 9%, the return on the SMB portfolio (rSMB) is 2.6%, and the return on the HML portfolio (rHML) is 5.4%. If ai = 0, bi = 1.2, ci = -0.4, and di = 1.3, what is the stock's predicted return? Do not round intermediate calculations. Round your answer to two decimal places.
According to the Fama and French 3-factor model,do you think that the three factors included make...
According to the Fama and French 3-factor model,do you think that the three factors included make up a logical explanation of how share returns may be explained? What criticisms could be made of the model? (give academic support or example)
Does the Fama and French 3 factor model argue their Small Minus Big factor reflects the...
Does the Fama and French 3 factor model argue their Small Minus Big factor reflects the extra riskiness of small stocks relative to large stocks?
Answer anyone question Question 1:  Fama and French (1993) have included a Size factor in their 3-factor...
Answer anyone question Question 1:  Fama and French (1993) have included a Size factor in their 3-factor model. Survey the most recent literature and discuss whether the Size factor is still present in financial markets (in the US and elsewhere). Using the Methodology of Fama and MacBeth (1973), test and discussion possible economic reasons why Size should be a priced factor. Requires a large literature base and a simple regression analysis. If you are fully prepared, I hope to write this...
You model the stock returns using the Fama-French 3-factor model. The expected return for the market...
You model the stock returns using the Fama-French 3-factor model. The expected return for the market is 14%, the risk-free rate is 2%, the expected return on the Small-Minus-Big (SMB) portfolio is 2%, and the expected return on the High-Minus-Low (HML) portfolio is 1.8%. Canopy Growth Corporation (CGC) as a beta with respect to the market of 0.9, a beta with respect the SMB portfolio of -0.14, and a beta with respect to the HML portfolio of 0.1. According the...
You model the stock returns using the Fama-French 3-factor model. The expected return for the market...
You model the stock returns using the Fama-French 3-factor model. The expected return for the market is 14%, the risk-free rate is 2%, the expected return on the Small-Minus-Big (SMB) portfolio is 1%, and the expected return on the High-Minus-Low (HML) portfolio is 1.3%. Canopy Growth Corporation (CGC) as a beta with respect to the market of 0.9, a beta with respect the SMB portfolio of -0.12, and a beta with respect to the HML portfolio of 0.11. According the...
ADVERTISEMENT
ADVERTISEMENT
ADVERTISEMENT