What is Fama And French Three Factor Model?

2559 reads · Last updated: December 5, 2024

The Fama and French Three-Factor Model 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 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.

Definition

The Fama-French Three-Factor Model is an asset pricing model introduced in 1992. It builds on the Capital Asset Pricing Model (CAPM) by adding size risk and value risk factors. The model accounts for the fact that value stocks and small-cap stocks often perform well in the market. By including these two additional factors, the model adjusts for this tendency and is considered a better tool for evaluating manager performance.

Origin

The Fama-French Three-Factor Model was proposed by Eugene Fama and Kenneth French in 1992. The model was developed to improve upon the CAPM, which only considers the market risk factor. Fama and French, through empirical research, found that size and value factors significantly impact stock returns, thus incorporating them into the model.

Categories and Features

The Fama-French Three-Factor Model includes three main factors: the market risk factor, the size factor, and the value factor. The market risk factor is the same as in CAPM, reflecting the overall market volatility. The size factor (SMB) considers that small-cap stocks typically have higher returns than large-cap stocks. The value factor (HML) reflects that value stocks (high book-to-market ratio) generally outperform growth stocks (low book-to-market ratio). The model's advantage lies in better explaining the variability of stock returns, but it also increases the model's complexity.

Case Studies

A typical case is the performance of small-cap stocks in the early 2000s. Many small-cap companies performed well after the dot-com bubble burst, and the Fama-French model could explain this phenomenon because it considers the size factor. Another case is the recovery performance of value stocks after the 2008 financial crisis. Value stocks rebounded quickly after the crisis, and the Fama-French model explained this through the value factor.

Common Issues

Common issues investors face when applying the Fama-French Three-Factor Model include accurately estimating the size and value factors and the stability of these factors under different market conditions. Additionally, the model's complexity may lead to overfitting issues, so investors need to use it cautiously.

Suggested for You

Hurdle Rate

The Hurdle Rate, also known as the Minimum Acceptable Rate of Return (MARR) or Required Rate of Return (RRR), is the minimum rate of return on an investment project that a company or investor is willing to accept before proceeding with the investment. This rate is set by the company's management or investors and serves as a benchmark for evaluating the feasibility of investment projects. The hurdle rate takes into account the cost of capital, risk premium, and other factors to ensure that the investment yields sufficient returns to compensate for the risks involved. If the expected return on a project is below the hurdle rate, the project is typically rejected. The hurdle rate is crucial in capital budgeting and project evaluation, aiding companies in effective resource allocation and risk management.

Horizontal Spread

A Horizontal Spread, also known as a Time Spread or Calendar Spread, is an options trading strategy. This strategy involves simultaneously buying and selling options contracts with the same strike price but different expiration dates. Typically, a trader will buy a long-term option and sell a short-term option. The goal of a horizontal spread is to profit from the difference in time value, especially when the underlying asset's price is not expected to move significantly. By employing this strategy, traders can benefit from the different rates of time decay (the reduction in the value of an option as it approaches its expiration date). Horizontal spreads are suitable for investors who have an expectation of market volatility but are uncertain about the specific direction of the price movement.

Box Spread

A box spread, or long box, is an options arbitrage strategy that combines buying a bull call spread with a matching bear put spread. A box spread can be thought of as two vertical spreads that each has the same strike prices and expiration dates.Box spreads are used for borrowing or lending at implied rates that are more favorable than a trader going to their prime broker, clearing firm, or bank. Because the price of a box at its expiration will always be the distance between the strikes involved (e.g., a 100-pt box might utilize the 25 and 125 strikes and would be worth $100 at expiration), the price paid for today can be thought of as that of a zero-coupon bond. The lower the initial cost of the box, the higher its implied interest rate. This concept is known as a synthetic loan.

Equity Fund

An equity fund is an investment vehicle that pools money from many investors to be managed by professional fund managers, primarily investing in the stock market. The goal of an equity fund is to achieve capital appreciation by investing in various companies' stocks. Depending on the investment strategy and objectives, equity funds can be classified into actively managed equity funds and passively managed equity funds. Actively managed equity funds involve fund managers actively selecting and adjusting the stock portfolio to achieve returns that exceed the market average. Passively managed equity funds typically track a specific stock index, such as the S&P 500, aiming to replicate the performance of that index.

Stock Dividend

A stock dividend is a payment made by a corporation to its shareholders in the form of additional shares, rather than cash. When a company earns a profit, it may choose to distribute part of it to shareholders by issuing new shares. Each shareholder receives a proportionate number of additional shares based on their existing holdings. The issuance of stock dividends does not alter the total market value of the company but increases the total number of shares outstanding, thereby diluting earnings per share. Stock dividends are typically used when a company wants to retain cash for reinvestment or other purposes while still providing a return to shareholders.

Stock Split

A stock split is a corporate action in which a company increases the number of its outstanding shares by issuing more shares to current shareholders, thereby reducing the price per share. A stock split does not change the company's overall market capitalization or the total value of a shareholder's holdings; it merely reduces the price per share while increasing the number of shares held by each shareholder. For example, in a 2-for-1 stock split, each share held by a shareholder is split into two shares, and the price of each share is halved. Stock splits are typically undertaken when a company's share price has become relatively high, making the shares more affordable and attractive to investors.