Equity Risk Premium in Fama-French

[prodigal]

Hello All,

In return concepts, the equity risk premium in the FFM is calculated by
risk premium = market factor + size factor + value factor
In size factor, you short a large-cap stock and invest proceeds in a small-cap.

In value factor, you short a low book/mrkt and invest proceeds in high book/mrkt. This I understand. You want to bet on the price of a low bk/mrkt stock going down and invest where the market has undervalued the stock. Under valuation implies high bk/mrkt value.

In PS model there is an additional liquidity term. Short high-liq and invest proceeds in low-liq. How can the size and liquidity factor be understood? Why would you want to short a large-cap or a high-liquidity stock?

Thanks for your time.
P

 

[Systematic]

You don’t understand the factors. You aren’t shorting any of them, its the difference in returns between the High & Low.
If the Russell 1000 has a return of 2% last month and the Russell 2000 has a return of 3% the size factor for the month is 1%. It shows you the payment for the risk premium so that you, the investor, understands that small cap stocks are riskier than large, and for that you expect to be compensated an additional x% annually.

 

[cpk123]

+ 3 - 2 = 1% from your example - means you sold the Russell 2000 (got 3%) and bought the Russell 1000.
Sold = Short
and then Invest

 

[Systematic]

These factors are regression independant variables used to explain the cross section of market returns… they aren’t necessarily intended to be strategies by themselves. My example is meant to show the return of small caps over large. The 3 factor model explains stock returns.