Fama-French Model

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haiderraza

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Hi,
I was readig thru these statements of FF model. These two are factors in FF which determine the required return.
  • SMB (small minus big), a size (market capitalization) factor. SMB is the average return on three small-cap portfolios minus the average return on three large-cap portfolios. Thus SMB represents a small-cap return premium.
  • HML (high minus low), the average return on two high book-to-market portfolios minus the average return on two low book-to-market portfolios. With high book-to-market (equivalently, low price-to-book) shares representing a value bias and low book-to-market representing a growth bias, in general, HML represents a value return premium.
 
Thanks for the information, looking forward to tomorrow’s post of the day.
 
Is there a question buried in here or are we just regurgitating random paragraphs from the curriculum?
 
It says that the CAPM fails to capture risk premia using only beta. And small cap companies outperform big cap companies. Likewise, companies with low P/B ratios outperform companies with high P/B ratios. And thus a premium should be discounted from the present value.
However, if you use the CAPM properly, you wouldn’t generally need to use the FFM.
 
putting it in another words, FF model assumes that Value(small) companies tend to outperform growth(large) companies. Practically, Beta is not the only risk factor to value particular stock, hence FF model captures the premium on smaller size companies and premium on bookvalue of small companies v/s large companies. (small companies tend to be riskier than large companies).

SMB (size) > should be a positive no. to support the above assumption.

HML (Book to Market value) > should be positive/higher no. as well (recall that growth/large companies invest more for the future growth, so they left with lower book value Hence, BV to market Ratio for them should be lower compared to smaller companies)
 
^
It doesn’t assume, it’s based on emperical evidence.
Although now, better models are accepted, because a liquidity premium would explain the SMB permium, and a SMB explains almost all of the FFM superiority over the CAPM.
 
Thank you Mr.Smart and Sanjay.
I really appreciate your responses. got the point
 
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