There are many different asset pricing and portfolio management models available to assist us in the estimation and evaluation of a stock’s return. The Fama-French Model (“FFM”) is one of those models. Kenneth French and Eugene Fama who were professors at the University of Chicago Booth School of Business designed the FFM. Kenneth French and Eugene Fama observed that historically, the Capital Asset Pricing Model (“CAPM”), which was predominantly used, was inaccurate as it often resulted in high alpha values which meant that a huge portion of excess returns were left unexplained. They also observed that companies with smaller market caps would outperform companies with higher market caps and companies with higher book-to-market (“B/E”)
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This would form the excess returns that small firms have over larger firms and the firm specific beta will be assigned to it to formulate the value of SMB, accounting for the size risk factor. This is based on the assumption that smaller firms tend to experience higher excess returns. Accordingly, if β_SMB is larger than 0, it means that the portfolio would have higher expected returns signifying that it consist mostly of small companies and vice versa. This assumption is in line with the fact that smaller companies are riskier than larger companies. As the general rule that the higher the risk the higher the returns, it is only fitting that companies with smaller market caps thus higher risk would bring in higher returns. This occurs because the smaller firms are usually not very popular hence; there are not many investors that are interested in the stock consequently, the share price would be relatively low, giving it room to perform better. On the other hand, firms with larger market cap are traded often due to investor’s interest, causing their share price to be high. Evidence of this can be found in a report issued by a research company Duff and Phelps (2013). It shows that in a 30 year period, small companies has out performed large companies 92% of the time, further proving that size factor plays a huge part in evaluating the returns of a

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## Literature Review: The Fama-French Three Factor Model

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This paper was especially important, because it took all the research that had been done in the last 30 years and combined it into one formula, now known as the Fama-French Three Factor Model. What Fama and French did was using the old CAPM and then adding much of the critique explained in the above text. This gave some very interesting results. One of the first things they discovered was that the relation between the beta and the return was not quite true. Because of the (negative) correlation between company size and beta, beta and return only seemed to have a relation but when Fama and French adjusted for this correlation, the relation between beta and return pretty much vanishes. Because of this result, Fama and French decided to look for other variables that might explain the average returns. After some calculation, they tested whether size, E/P, leverage, Book to Market and beta, again following the findings that researchers had done before them. A few very important conclusions of their research are: 1) If variation in B that is unrelated to size is allowed, there is no reliable relation between B and average return. 2) The opposite roles of market leverage and book leverage in average returns are captured well by book to market equity. 3) The relation between E/P and average return seems to be absorbed by the combination of size and market to book equity. The latter means that there is no need to include E/P in the model, because the effect of E/P is already reflected by Size and Book to Market equity. With these findings, Fama and French completed their new model. This new Fama-French Three Factor Model was a severe blow for everybody that still believed in the power of the CAPM and it is not surprising that many scientists wanted to prove them wrong. In 1993 Fama and French extended on their paper from 1992 in three ways; they expanded the set of asset returns to be explained. The assets that

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