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Models of Asset Returns - APT-4-5

The Fama and French three-factor model extends the CAPM by including two additional factors - firm size and the book-to-market ratio. It aims to better explain returns by accounting for the empirically observed small firm effect and value premium, where smaller companies and those with higher book-to-market ratios tend to generate higher returns on average.

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Dani Sha
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36 views2 pages

Models of Asset Returns - APT-4-5

The Fama and French three-factor model extends the CAPM by including two additional factors - firm size and the book-to-market ratio. It aims to better explain returns by accounting for the empirically observed small firm effect and value premium, where smaller companies and those with higher book-to-market ratios tend to generate higher returns on average.

Uploaded by

Dani Sha
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Fama and French three factor model

 It can be seen that the Fama and French three-factor model is more like an
extension of the CAPM.
 It includes the two factors identified by Fama and French (1992a), firm size and
book-to-market equity (BE/ME), in addition to the market factor.
 In fact, the model augments the CAPM model by the size effect and the book-
to- market equity effect.
 The small firm effect is one of the most extensively studied anomalies in finance.
 The classic studies of the small firm premium are those of Banz (1981) and
Reinganum (1981). The size effect is the empirical regularity that firms with small
market capitalization exhibit returns that on average significantly exceed those
of large firms.
 The book-to-market equity effect shows that average returns are greater the
higher the book value to market-value ratio (BE/ME) and vice versa. It is also
referred to as the value premium.
Arbitrage pricing theory
 Arbitrage pricing theory (APT), originally developed by Ross, is an equilibrium market model that
does not rely on the strong assumptions of the CAPM.
 E.g. assumption regarding investors’ preferences are no longer required; though homogeneous
expectations is still required.
 Nor is it necessary to identify all risky assets or a “market portfolio” in order to test it.
 As a consequence it is both more general and more easily testable than the CAPM, although
there are still difficulties in testing its applicability.
 Instead, it is based upon the assumption of an investment world that is arbitrage-free.
 Define what is meant by arbitrage:

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