exam7. Explain the Fama-French three-factor model. Is beta a useful measure of risk in this model? Should we rationally expect small stocks to outperform large stocks in the future? Value stocks to outperform growth stocks?
Fama and French’s three factor model attempts to explain the variation of stock prices through a multifactor model that includes a size factor, small-minus-big (i.e. small stocks may be more sensitive to changes in business conditions than large stocks) and BE/ME factor, high-minus-low (i.e. high book to market value stocks are more likely to be in financial distress) in addition to the beta risk factor. Fama-French model essentially extended the CAPM by introducing these two additional factors. These two factors are empirically examined that historical average returns on stocks of small firms and on stocks with high ratios of book to market equity are higher than predicted by the security market line of the CAPM. These observations advise that size or the book to market ratio may be proxies of systematic risk not captured by the CAPM beta. μi = rf + (μm – rf) * ß + bs * SMB + bh * HML
Fama and French find that stocks with high beta didn’t have consistently higher returns than stocks with low beta and this indicates that beta was not a useful measure under their model. Their model is based on research findings that sensitivity of movements of the size and BE/ME factor recognizes risk, and therefore risks associated with small companies and risks associated with high BE/ME companies in addition to beta risk explain a great deal of the variation of stock prices. The value premium of small stocks over large stocks as compensation for the additional risk that a small company has is more likely to fail than a large company that has more assets. R. Banz discovered that historical performance of portfolios made by dividing the NYSE stocks into 9-10 portfolios each year according to firm size, average annual returns between 1926 through the late...
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