Question

In Fama and French (1993), what are the three factors in their new model that significantly influence the expected return of a stock? Briefly explain.

Answer 1

The Fama-French three-factor Model is an extension of the Capital Asset Pricing Model (CAPM). The Fama-French model aims to describe stock returns through three factors:

(1) Market risk

(2) The outperformance of small-cap companies relative to large-cap companies

(3) The outperformance of high book-to-market companies versus low book-to-market companies.

The rationale behind the model is that high value and small-cap companies tend to regularly outperform the overall market.

1. Market Risk Premium

Market risk premium is the excess return over the risk free rate

2. Outperformance of small cap as compared to large cap companies

The main rationale behind this factor is that in the long-term, the small-cap companies tend to see higher returns than large-cap companies.

3. Outperformance of high book-to-market companies versus low book-to-market companies.

This factor reveals that in the long-term, high book-to-market ratio company enjoy higher returns than low book-to-market ratio.