Fama–French three-factor model

The system developed by Eugene Fama and Kenneth French Fama - French three- factor model is a model of modern financial science that explains stock returns.

The traditional Capital Asset Pricing Model (CAPM ) uses only a stock-specific variable, beta, to explain the return of a portfolio or a stock with the market return. The Fama - French three- factor model, in contrast, uses three variables. Fama and French presented first, that shares with two certain characteristics performed better than the overall market: ( i) stocks with small market capitalization and ( ii ) shares with a high ratio of book value and market value of equity, also known as value stocks. Therefore they extended the CAPM two factors that reflect the risk of stock with respect to said features:

Here r is the portfolio or stock return, the return on the risk- free interest rate and the return on the overall market. The "three factors " is similar to the classic but not identical because the two additional factors also provide an explanatory contribution. stands for "small (market capitalization ) minus big" and "high ( book - market ratio ) minus low"; they measure the return difference between small and large stocks, and between value and growth stocks. These factors are calculated with the help of portfolios, which shares were assigned on the basis of their market capitalization and its book - market value ratio. Historical time series for the U.S. stock market are available on Kenneth French 's website.

After SMB and HML are present, the associated coefficients and by means of a linear regression are estimated and may assume both positive and negative values. The Fama - French three- factor model explains for the U.S. stock market more than 90 % of the variance of the portfolio returns, whereas the CAPM can explain only 70 % on average.

Griffin shows that the Fama - French factors are country-specific and describes that local factors better explain the temporal variance of the stock returns as global factors. Why are updated risk factors for other equity markets, including UK, Germany and Switzerland, available. Eugene Fama and Kenneth French recently compared multi-factor models with global and local risk factors for four regions (North America, Europe, Japan and Asia / Pacific) and concluded that local risk factors better be priced regional portfolios as global risk factors. The time series of local and global risk factors are also available on Kenneth French 's website.