Fama and French Three

Factor Model
Financial Management
Fama and French Three Factor 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 stocks 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.
Important Points
• The Fama French 3-factor model is an asset pricing model that
expands on the capital asset pricing model by adding size risk and
value risk factors to the market risk factors.
• The model was developed by Nobel laureates Eugene Fama and his
colleague Kenneth French in the 1990s.
• The model is essentially the result of an econometric regression of
historical stock prices.
• The Formula for the Fama French Model Is:
Return = Rf + β1(Rm - Rf) + β2SMB + β3HML
• Here (Rm - Rf) is the risk premium
• SMB is the size premium
• HML is value premium
Research has shown that this model is a better presentation of the return
than CAPM.
Small and Big Companies
• The variable in Fama and French three factor model is SMB, which
stands for Small minus Big.
• Here small and big refer to market capitalization
• Small market cap companies perform better than the big market cap
companies and hence there is an addition return if there are more small
cap companies i.e. Small minus Big or SMB
High and Low Value Stocks
• Here High and Low values are the Book to Market price ratios
• Companies with high B/M ratio perform better than the low B/M ratio
and hence a premium is created called High minus Low or HML.
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. 
• So the portfolios having more high value (Book to Market Value)
stocks are likely to earn higher return
• Similarly, the portfolios having more Small-cap (small market
capitalization-market capitalization is the product of market price and
number of outstanding shares) are likely to earn higher return
What Is a Value Stock?
• A value stock is a stock that trades at a lower price relative to its
fundamentals, such as dividends, earnings, or sales, making it appealing to
value investors.
• Opposite of this is Growth Stocks; those stocks which sell in the market at a
price higher than their fundamentals
• Common characteristics of value stocks include high dividend yield, low P/B
ratio and/or a low P/E ratio.
• A value stock typically has a bargain-price as investors see the company as
unfavorable in the marketplace.
• A value stock typically has an equity price lower than stock prices of
companies in the same industry.
Four Factor Model
• Fama and French model is based on three variables, which contribute to
the return of investors i.e. access return Rm – Rf, SMB, and HML.
• Later researchers also added another variable i.e. Momentum.
• Momentum is described as the difference of Winning and Losing stocks
i.e. stocks gone up (winners) and stocks gone down (losers).
• Also in 1993, Jegadeesh and Titman found that adding a fourth factor,
momentum, enhanced portfolio returns. 
• Momentum is calculated by buying the stocks of firms that have
increased in price while selling the stocks of firms that previously
decreased in price (winners minus losers).
• Mark M. Carhart in 1997 applied the momentum factor and added it as
the fourth factor in Fama and French Model
• The results support that adding this factor increases the returns of
portfolios
 Multifactor Return Models: Arbitrage
Pricing Theory
• the Arbitrage Pricing Theory (APT) is a multi-factor asset
pricing model based on the idea that an asset's returns can be
predicted using the linear relationship between the asset’s
expected return and a number of macroeconomic variables
that capture systematic risk.
Example of How Arbitrage Pricing Theory
Is Used
• For example, the following four factors have been identified as explaining a
stock's return and its sensitivity to each factor and the risk premium
associated with each factor have been calculated:
• Gross domestic product (GDP) growth: ß = 0.6, RP = 4%
• Inflation rate: ß = 0.8, RP = 2%
• Gold prices: ß = -0.7, RP = 5%
• Standard and Poor's 500 index return: ß = 1.3, RP = 9%
• The risk-free rate is 3%
• Using the APT formula, the expected return is calculated as:
• Expected return = 3% + (0.6 x 4%) + (0.8 x 2%) + (-0.7 x 5%) + (1.3 x 9%)
= 15.2%