The Fama-French Three-Factor Model is a pivotal finance framework developed by Eugene F. Fama and Kenneth R. French. It enhances the Capital Asset Pricing Model by incorporating two additional factors—size and value—alongside market risk to explain stock returns. This model is instrumental in portfolio analysis and investment strategy, offering insights into the risks and expected returns of different stock categories. It uses three key risk factors: market risk, SMB (Small Minus Big), and HML (High Minus Low), to provide a more nuanced understanding of asset performance.
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The Fama-French Three-Factor Model was developed to provide a more comprehensive framework for understanding the risks associated with expected returns on investments
Market Risk
Market risk, similar to the Beta in CAPM, measures a portfolio's sensitivity to the overall market
SMB (Small Minus Big)
SMB measures the excess returns of small-cap stocks over large-cap stocks
HML (High Minus Low)
HML captures the excess returns of value stocks over growth stocks
The Fama-French model is articulated through an equation that forecasts expected returns using the three risk factors, and can be analyzed through regression analysis to quantify the expected additional return per unit of risk associated with each factor
Regression analysis is used to discern the influence of each risk factor on portfolio returns
The Fama-French model allows for a more precise attribution of performance, differentiating between returns attributable to market exposure and those resulting from specific investment choices
The Fama-French model extends the CAPM by considering additional risk factors beyond market risk
The Fama-French model can be used to calculate the Beta values for potential investments, reflecting each asset's sensitivity to the three risk factors
The Fama-French model can inform asset allocation decisions, allowing investors to tailor their portfolios to their desired exposure to market, size, and value risks
By balancing market, size, and value risks, investors can create a portfolio that meets their risk-return preferences and anticipates market trends
The Fama-French model provides a more thorough risk assessment, enhancing return predictions and supporting dynamic portfolio management
The Fama-French model is based on historical market data, giving it a strong empirical foundation and making it an indispensable tool for long-term investment planning and scholarly inquiry in finance
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Developed by ______ and ______, the model serves to understand risks and expected returns on investments better than CAPM.
Eugene F. Fama
Kenneth R. French
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Market Risk in Fama-French Model
Reflects portfolio's sensitivity to overall market, similar to Beta in CAPM.
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SMB Factor Significance
Represents excess returns of small-cap stocks over large-cap stocks.
