Fama-French Three-Factor Model

DFA’s investment strategy is based on their belief in the principle that stock market is efficient. They attempt to match a broad-based, value-weighted small-stock index and position themselves in the market as a passive fund manager that still claimed to add value by capturing specific dimensions of risks identified by financial science. DFA’s investment strategy incorporates elements of both passive and active management. It is passive in the sense that like many other index managers, it focuses on the importance of diversification, lower turnover and lower fees than actively managed portfolios. It is active in the sense that it develops its small-value stock focus based on academic research and uses certain techniques (such as

CAPM is a model that describes the relationship between risk and expected return, and the formula itself measures the expected return of the portfolio. Mathematically, when beta is higher, meaning the portfolio has more systematic risk (in comparison to the market portfolio), the formula yields a higher expected return for the portfolio (since it is multiplied by the risk premium and is added to the risk free interest rate). This makes sense because the portfolio needs to

The CAPM is a single factor model because it based on the hypothesis that required rate of return can be predicted using one factor that being systematic risk. It looks at risk and rates of returns, compares then to the stock market providing a usable measure of risk to help investors determine what return they will get for risking their money in an investment. There are a lot of assumptions and drawbacks of CAPM that lead to the conclusion that those investors utilizing this

Utilizing the fundamental concepts of the Capital Asset Pricing Model (CAPM), the expected return for Wal-Mart stock is 7.01% [E(R)]. This is a result of a risk-free rate (Rf) of 3.68%, which was the provided 10-year government bond yield to use as a proxy for the risk-free rate. The beta (β ) of Wal-Mart was 0.66 according to the provided Bloomberg beta estimate. Additional data was provided on the U.S. market risk premium [E(RM) – Rf] of 5.05%. In following the general concepts of CAPM, there are some general assumptions: no transaction costs, all assets are publicly traded,

This could also work to the firm’s disadvantage, since gathered intelligence should never be considered static. New developments are always transpiring that render recently collected intelligence obsolete and invalid. The firm that fails to recognize this will have surely wasted its CI efforts.

CAPM results can be compared to the best expected rate of return that investor can possibly earn in other investments with similar risks, which is the cost of capital. Under the CAPM, the market portfolio is a well-diversified, efficient portfolio representing the non-diversifiable risk in the economy. Therefore, investments have similar risk if they have the same sensitivity to market risk, as measured by their beta with the market portfolio.

Investors hold diversified portfolios : One of the assumptions of CAPM model is that investors are holding only portfolios which are subjected to systematic risk , the unsystematic risk can be ignored , therefore the unsystematic risk has been ignored (Lakonishok & Shapiro , 1986)

To justify whether it works, we first ran a regression on the Three-Factor Fama French Model (Market Excess Return, SMB and HML) from Jan 1972 to Dec 2012 respectively for the High-, 5-, Low-, and High-Minus-Low Portfolio. Then, we added momentum into the model to create a four-factor model (Momentum, Market Excess Return, SMB and HML) for the same period on a monthly basis. (See Exhibit 2).

CAPM on the other hand is based on microeconomic ideas such as concave utilities and costless diversification. Macroeconomic events mentioned include interest rates or the cost of labor, causes the systematic risk that affects the returns of all stocks. On the other hand the firm-specific events are the unexpected microeconomic events that affect the returns of specific firms for example the death of key people that would affects the firm, but would have a insignificant effect on the

In order to test the validity of the CAPM, we have applied the two-step testing procedure for asset pricing model as proposed by Fama and Macbeth (1973) in their seminal paper.

According to this Fama & French three factors model, there are two more variable added into the regression model. They are SML factor (the return of small cap companies minus the the return of large cap companies) and HML factor (the

The important implication of this is that investors cannot consistently outperform the market, and if they do it is purely through luck. With competition for information reaching new heights, professional managers face greater difficulties in attempting to outperform each other. If these professionals are unable to consistently beat the market, there remains little hope for the average investor.

Mutual fund also offers good investment opportunities to the investors. Like all investment, they also carry certain risks. The investors should compare the risks and expected yields after adjustment of tax on various instruments while taking investment decisions. The Indian mutual fund industry has witnessed several structural and regulatory reforms.

Hence, Fama & French’s three factor model flourished when considering the market book value and the size of business. Additionally, in Fama and French’s (1996) paper, they concluded Sharpe – Lintner’s CAPM has never been an empirical success. According to the current study, the factors that affected the Beta are serious enough to invalidate most applications of the CAPM

Now I will discuss the results of some past paper on four factor model of CAPM. The four factor model represents an asset pricing model developed by Carhart (1997) owing to the fact that the three factor model of Fama-French (1993, 1996) could not explain the momentum effect presented by Jegadeesh-Titman (1993).