Fama & French Model

What is Fama & French Model?

The Fama and French Three-Component Model (or Fama French Model) is a 1992 asset pricing model that builds on the capital asset pricing model (CAPM) by adding size and value risk elements to the market risk factor.
This model considers that value and small-cap stocks consistently beat the market. The model adjusts for this outperforming tendency by integrating these two additional criteria, making it a more potent tool for measuring management effectiveness.

Example of Fama & French Model:

$ E\left ( R_{i} \right )= R_{f}+\beta _{i,M}RP_{M}+\beta _{i,SMB}F_{SMB}+\beta _{i,HML}F_{HML}+\epsilon _{i} $

E(R_i) is Expected Return

R_F is Risk-Free Rate

β_i,M is Market Beta

RP_M is Risk Premium

β_i,SMB is Beta of Smaller Minus Big Firms

F_SMB is Constant for Smaller Minus Big Firms

β_i,HML is Beta of High book to market value firms

F_HML is constant of High book to market value firms

β_i is Error Term

SMB and HML factors are chosen because history shows that returns are higher on smaller firms and those with high book-to-market values.
Fama and French argue that these differences exist because small firms are inherently riskier than big firms.

Why is the Fama French model important?

The Fama-French Three-Factor Model is a powerful tool for analysing portfolio performance, assessing the influence of active management, constructing portfolios, and forecasting future returns.