What is Fama And French Three Factor Model Formula

What is Fama and French? The three-factor model, the Fama, and French, developed by professors Eugene Fama and Kenneth French, enhances the capm by adding two risk factors to better explain stock returns, unlike the capm, which relies solely on beta or market exposure. The French model assesses three factors.

What is Fama And French Three Factor Model Formula

Market risk beta: small minus big SMB and high minus low HML SMB captures the historical trend where small-cap companies outperform large-cap ones, while HML highlights that high-book-to-market-value firm stocks often outperform low-book-to-value firms gross stocks This model assumes small cap and high-value firms generate higher long-term returns, providing a more nuanced view of expected market returns.

Initially tested in Canada and Japan, the US and UK models later expanded to Europe and the Asia-Pacific. After refinements, the formula incorporates a risk-free rate. Market risk premium and coefficients for SMB and HML, which are calculated through regression to measure sensitivity to each factor, make it more flexible and accurate than CapM as it explains 90% of portfolio diversification according to Fama and French's research.

Importantly, this model aligns with the notion that higher risk tends to yield higher returns, benefiting long-term investors who can withstand short-term market volatility. The three-factor model assists investors in understanding portfolio performance, stock returns, and price movements, helping to identify market trends.

Beyond those captured by Beta alone, however, it assumes rational pricing of stocks and recognizes limitations, particularly around measurement errors in the value factor The model was extended further to a five-factor version, introducing profitability and investment as additional components that reflect expectations about companies with high future earnings or significant investment and projects by encompassing market risk firm size and value.

The Fama and French model offers a comprehensive framework for investors aiming to maximize returns through strategic exposure to these risk factors, proving especially popular among those seeking long-term gains and enhancement.