Question

Fama and French argue their Small Minus Big factor reflect the extra riskiness of small stocks relative to large stocks. Do you believe they are correct give reasons for your answer.

Answer 1

The Fama and French is an extension of the CAPM model where instead of relying on one factor we are segregating the risk component to other factors rather than just beta. SMB also known as the small firm effect which basically to illustrate the difference between the small capitalization companies and large market capitalization companies. There are actually many factors which makes the small firm riskier than the large cap firms. One of them is the liquidity of the stock. It is comparatively very easy to buy and sell large quantity of stocks because the liquidity in the large cap stocks is normally very high but the liquidity in the small cap is not that high. The ability of a large companies to withstand the economic volatility is more than the small cap companies. Also, the small cap companies is followed by less analyst as compared to large cap companies so the information asymmetricity is also one of the reasons. That is why small firm effect risk premium is added also known as size premium.