Fama And French Three Factor Model

AAA

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.

INVESTOPEDIA EXPLAINS '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.

RELATED TERMS
  1. International Capital Asset Pricing ...

    A financial model that extends the concept of the capital asset ...
  2. Efficient Market Hypothesis - EMH

    An investment theory that states it is impossible to "beat the ...
  3. Capital Asset Pricing Model - CAPM

    A model that describes the relationship between risk and expected ...
  4. Value Stock

    A stock that tends to trade at a lower price relative to it's ...
  5. Small Cap

    Refers to stocks with a relatively small market capitalization. ...
  6. High Minus Low - HML

    One of three factors in the Fama and French asset pricing model. ...
Related Articles
  1. The Capital Asset Pricing Model: An ...
    Fundamental Analysis

    The Capital Asset Pricing Model: An ...

  2. Catch On To The CCAPM
    Fundamental Analysis

    Catch On To The CCAPM

  3. Investigating The Stock Premium Puzzle
    Investing

    Investigating The Stock Premium Puzzle

  4. Financial Concepts
    Options & Futures

    Financial Concepts

comments powered by Disqus
Hot Definitions
  1. Ghosting

    An illegal practice whereby two or more market makers collectively attempt to influence and change the price of a stock. ...
  2. Elasticity

    A measure of a variable's sensitivity to a change in another variable. In economics, elasticity refers the degree to which ...
  3. Tangible Common Equity - TCE

    A measure of a company's capital, which is used to evaluate a financial institution's ability to deal with potential losses. ...
  4. Yield To Maturity (YTM)

    The rate of return anticipated on a bond if held until the maturity date. YTM is considered a long-term bond yield expressed ...
  5. Net Present Value Of Growth Opportunities - NPVGO

    A calculation of the net present value of all future cash flows involved with an additional acquisition, or potential acquisition. ...
  6. Gresham's Law

    A monetary principle stating that "bad money drives out good." In currency valuation, Gresham's Law states that if a new ...
Trading Center