Question

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 1

The Fama and French is a multifactor Stock pricing model that is basically an extension of the Capital asset pricing model (CAPM) and takes into account three factors ,which are mentioned in the equation below :

E(Rp) = Risk free rate + (Beta * market risk premium ) + ( Beta size * SMB ) + (Beta value * HML ) + alpha

Here , SMB is Small Minus Big and Beta size  is the beta associated with small cap stocks

HML is High Book to market value of stocks Minus Low Book to market value Beta value  is the beta associated with certain stocks

Alpha is the stock specific shocks

So Fama and french model basically says that Historically small cap stocks have earned higher returns than large cap stocks . So if on an average small cap stocks give 18% return and large cap stocks give 10% return , then there should an SMB premium of 18-10 ie 8% that reflects the extra riskiness of small cap stocks. It should be remembered that the SMB factor will come into play only for small cap stocks . For large cap stocks the SMB premium and Beta size both will be zero . Generally if a stock has higher beta ( more than 1 ) it can be considered a small cap stock as it is higher volatility stock than the average market stocks and should earn higher returns since risk and return go side by side.