Introduction
The Fama and French model is the updated form or has evolved from the primary Capital Asset Pricing Model (CAPM). When dealing with shares and stocks, knowing about all these related models is pertinent, which will help you analyze the returns and market values. The risk factors involved in trading the stocks and associated returns of the portfolio are calculated using such formulas of the model.
As there are two types under the name Fama french model itself, we will look at how the Fama and French Three Factor Model works. This guide will shed light on the principle and the formula with relevant examples.
Formula and Explanation
The formula for Fama French Model is simple, and anyone with proper knowledge about the stock exchange will be able to understand it quickly. It is written as:
Where,
ra is the rate of return
rf is the risk-free rate
ß is the factor of coefficient for sensitivity
(rm – rf) is the market risk premium
SMB is Small Minus Big
HML is High Minus Low
α is the investment’s alpha factor and;
e is the total risk.
This innovative formula for the Fama french 3-factor model makes predicting returns and risks easier.
The Principles on Which this Model Works
As this is a three-factor model, it works on three aspects or factors. They are:
- a) market risk
- b) size risk
- c) value risk.
To be precise, the detailed factor it runs on is the SMB and the HML. SMB is in line with the performance of small-cap companies over the large-cap companies. In comparison, HML is under the high book-market-value company versus the low book-to-market value company.
The size risk pertains to the Small Minus Big (SMB) factor. The beta coefficient in the formula can be either positive or negative. This coefficient concerns the capitalization of the company. It is believed under this model that small-cap companies can expect high rates of return when compared with large-cap companies. Therefore, the beta factor is vital for determining the risks.
The value risk is under the High Minus Low (HML) factor. The companies with a high book-to-market ratio will yield higher returns than the low book-to-market value companies. The book-to-market value is the difference between the predicted value in the book and the actual market value of the company.
If the coefficient factor is positive in the case of SMB, the returns are directed more towards a small-cap company. Similarly, if the coefficient is positive for the HML factor, the returns are more related to the high book-to-market value company.
There are two main aspects, namely the “value” and “growth.” In both cases, the returns pertain to value. If the condition is vice versa to the one cited above, the returns will be under the terms of growth and not value.
Why is this model considered the best?
The Fama and French Model is the advancement of the CAPM, a traditional model. This model knows and calculates the risk factors precisely. The risk-free rate is known to be applied when there are no possible risks while receiving the returns. The market risk premium is the estimated returns where the market with risks and risk-free markets are compared. All such important factors are used in applying the Fama and French models.
The fama french 5-factor model is more advanced as it includes two more factors: profitability and investment. These two factors are used in addition to the factors of the three-factor model.
As CAPM used only a single factor to assess the market risks, this model serves the best. Determining the beta coefficient factor with just a single element is challenging. Further, the volatility of the investment alone is estimated using the CAPM, and the risk-free rates determined might fluctuate from time to time. All such drawbacks can be overcome using the Fama and French Models.
Who can find this model to be useful?
Investors who are new to the field might not be able to find the model helpful as compared to experienced investors. As they might take time to understand all the terms and principles of trading, they can prefer simple methods to know the risks of returns after investment.
A professional investor can use this Fama and French model to know the intricate details of the returns. A mediocre investor can get help from an advanced analyst for investing in stocks. The analyst might then use the model to calculate the risks of the stock portfolio.
This model came into existence in 1992 and was developed by Eugene Fama and Kenneth French. The model’s name comes from their names, and there is no specific fama full form as such. Eventually, after the three-factor model, the five-factor model also developed.
Conclusion
Summing it up, a wise investor will gain lucrative profits without much loss by using this model. It is preferred to use Fama and French models and the related formula to know all the stock returns and market risks involved. Moreover, the working of the model must be thoroughly understood, and the relevant values should be appropriately applied. Therefore, one must invest only after knowing and accepting the risks involved in stock returns.
References
- https://corporatefinanceinstitute.com/resources/knowledge/finance/fama-french-three-factor-model/
- https://www.thebalance.com/what-is-the-fama-french-3-factor-model-5223585
- https://smartasset.com/investing/fama-french-3-factor-model
- https://www.fincash.com/l/basics/fama-and-french-three-factor-model
- https://www.investopedia.com/terms/f/famaandfrenchthreefactormodel.asp
- https://www.vskills.in/certification/tutorial/three-factor-model-of-fama-and-french/
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