Merger And Acquisition

Fama French Three-Factor Model

Babar Tanwri
Submitted to : Sir Farhan Khalil
 Outline

 Introduction

 Assumption

 Advantages

 Disadvantages
 Introduction

• The model was introduced by Eugene Fama and Kenneth French in 1992.
• It describes the expected return of a portfolio.

• The Fama and French Three-Factor Model is an asset pricing model 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.
 Cont:
• CAPM is a one-factor model, and that factor is the performance of the
market as a whole. This factor is known as the market factor. CAPM
explains a portfolio's returns in terms of the amount of risk it contains
relative to the market.

• The model essentially says there are two other factors in addition to
market performance that consistently contribute to a portfolio's
performance. One of the factor is SMB, if a portfolio has more small-
cap companies in it, it should outperform the market over the long run.

• Along with other factors, SMB is used to explain portfolio returns.

This factor is also referred to as the "small firm effect," or the "size
effect," where size is based on a company's market capitalization.
 Cont:
• The third factor in the Three-Factor model is High Minus
Low (HML). "High" refers to companies with a high book value to
market value ratio. "Low'" refers to companies with a low book value
to market value ratio.

• This factor is also referred to as the "value factor" or the "value

versus growth factor" because companies with a high book to market
ratio are typically considered "value stocks." Companies with a low
market to book value are typically "growth stocks." And research has
demonstrated that value stocks outperform growth stocks in the long
run.
• So, over the long run, a portfolio with a large proportion of value
stocks should outperform one with a large proportion of growth
stocks.
 Assumptions

•Market risk

•Outperformance of small capitalization companies to large capitalization

companies.

•Outperformance of high book to market companies to low book to market

companies.
 Conclusion

• The studies conducted by Fama and French revealed that the model could
explain more than 90% of diversified portfolios’ returns. Similar to the
CAPM, the three-factor model is designed based on the assumption that
riskier investments require higher returns.

• Nowadays, there are further extensions to the Fama-French three-factor

model, including four-factor and five-factor models.
Thank You