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Fama–French three-factor model

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Title: Fama–French three-factor model  
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Subject: Investment management, Variance risk premium, Performance attribution, Index fund, Fundamentally based indexes
Collection: Finance Theories, Financial Economics, Portfolio Theories
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Fama–French three-factor model

In asset pricing and portfolio management the Fama–French three-factor model is a model designed by Eugene Fama and Kenneth French to describe stock returns. Fama and French were professors at the University of Chicago Booth School of Business, where Fama still resides.

The traditional asset pricing model, known formally as the capital asset pricing model (CAPM) uses only one variable to describe the returns of a portfolio or stock with the returns of the market as a whole. In contrast, the Fama–French model uses three variables. Fama and French started with the observation that two classes of stocks have tended to do better than the market as a whole: (i) small caps and (ii) stocks with a low Price-to-Book ratio (P/B, customarily called value stocks, contrasted with growth stocks). They then added two factors to CAPM to reflect a portfolio's exposure to these two classes:[1]

r=R_f+\beta_3(K_m-R_f)+b_s\cdot\mathit{SMB}+b_v\cdot\mathit{HML}+\alpha

Here r is the portfolio's expected rate of return, Rf is the risk-free return rate, and Km is the return of the market portfolio. The "three factor" β is analogous to the classical β but not equal to it, since there are now two additional factors to do some of the work. SMB stands for "Small [market capitalization] Minus Big" and HML for "High [book-to-market ratio] Minus Low"; they measure the historic excess returns of small caps over big caps and of value stocks over growth stocks. These factors are calculated with combinations of portfolios composed by ranked stocks (BtM ranking, Cap ranking) and available historical market data. Historical values may be accessed on Kenneth French's web page.

Moreover, once SMB and HML are defined, the corresponding coefficients bs and bv are determined by linear regressions and can take negative values as well as positive values. The Fama–French three-factor model explains over 90% of the diversified portfolios returns, compared with the average 70% given by the CAPM (within sample). They find positive returns from small size as well as value factors, high book-to-market ratio and related ratios. Examining β and size, they find that higher returns, small size, and higher β are all correlated. They then test returns for β, controlling for size, and find no relationship. Assuming stocks are first partitioned by size the predictive power of β then disappears. They discuss whether β can saved and the Sharpe-Lintner-Black model resuscitated by mistakes in their analysis, and find it unlikely.[2]

Griffin shows that the Fama and French factors are country specific and concludes that the local factors provide a better explanation of time-series variation in stock returns than the global factors.[3] Therefore, updated risk factors are available for other stock markets in the world, including the United Kingdom, Germany and Switzerland. Eugene Fama and Kenneth French recently analysed models with local and global risk factors for four regions (North America, Europe, Japan and Asia Pacific) and conclude that local factors work better than global factors for regional portfolios.[4] The global and local risk factors may also be accessed on Kenneth French's web page.

A number of studies have reported that when the Fama–French model is applied to emerging markets the book-to-market factor retains its explanatory ability but the market value of equity factor performs poorly. In a recent paper, Foye, Mramor and Pahor (2013) propose an alternative three factor model that replaces the market value of equity component with a term that acts as a proxy for accounting manipulation.[5]

See also

References

  1. ^  
  2. ^  
  3. ^ Griffin, J. M. (2002). "Are the Fama and French Factors Global or Country Specific?".  
  4. ^  
  5. ^ Foye, J.; Mramor, D. A.; Pahor, M. (2013). "A Respecified Fama French Three-Factor Model for the New European Union Member States".  
  6. ^ Carhart, M. M. (1997). "On Persistence in Mutual Fund Performance".  

External links

  • The Dimensions of Stock Returns: Videos, paintings, charts and data explaining the Fama–French Five Factor Model, which includes the two factor model for bonds.
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