Fama And French Three Factor Model


DEFINITION of 'Fama And French Three Factor Model'

A factor model that expands on the capital asset pricing model (CAPM) by adding size and value factors in addition to the market risk factor in CAPM. This model considers the fact that value and small cap stocks outperform markets on a regular basis. By including these two additional factors, the model adjusts for the outperformance tendency, which is thought to make it a better tool for evaluating manager performance.


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BREAKING DOWN 'Fama And French Three Factor Model'

Fama and French attempted to better measure market returns and, through research, found that value stocks outperform growth stocks; similarly, small cap stocks tend to outperform large cap stocks. As an evaluation tool, the performance of portfolios with a large number of small cap or value stocks would be lower than the CAPM result, as the three factor model adjusts downward for small cap and value outperformance.

There is a lot of debate about whether the outperformance tendency is due to market efficiency or market inefficiency. On the efficiency side of the debate, the outperformance is generally explained by the excess risk that value and small cap stocks face as a result of their higher cost of capital and greater business risk. On the inefficiency side, the outperformance is explained by market participants mispricing the value of these companies, which provides the excess return in the long run as the value adjusts.

  1. International Capital Asset Pricing ...

    A financial model that extends the concept of the capital asset ...
  2. Small Cap

    Refers to stocks with a relatively small market capitalization. ...
  3. Efficient Market Hypothesis - EMH

    An investment theory that states it is impossible to "beat the ...
  4. Value Stock

    A stock that tends to trade at a lower price relative to it's ...
  5. High Minus Low - HML

    One of three factors in the Fama and French asset pricing model. ...
  6. Capital Asset Pricing Model - CAPM

    A model that describes the relationship between risk and expected ...
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