Analysis of CAPM and Three Factor Model
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October 27, 2022You are a consultant manufacturing economist: you will need to explain to a senior manager:
October 27, 2022Analysis of CAPM and Three Factor Model
Introduction
Capital Asset Pricing Model (CAPM) is the backbone of modern portfolio theory. According to CAPM, the expected return on stock is a function of its relationship with the market portfolio defined by its beta. However, Eugene Fama and Kenneth French (1992) brought together two more factors and found that stock return is based on a combination of not just market beta but also firm size and value. They came up with a new model known as Three Factor Model as an alternative to CAPM.
What is Fama and French Three Factor Model?
Fama and French three factor model expands on the 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 out-perform markets on a regular basis. Fama and French attempted to approach and measure equity returns in a different manner and found that value stocks outperform growth stocks and also small cap stocks tend to out perform large cap stocks. Thus, the performance of portfolios with a large number of small cap or value stocks is better than one with large cap and growth stocks but lower than the CAPM result. This is because the three factor model adjusts downward for small cap and value out-performance. However, the three factor model is considered to be a better model than its counterparts as by including two additional factors, the model adjusts for the out-performance tendency.
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The out-performance tendency of small cap stocks is a debated issue as out-performance may be considered as dependent on market efficiency or market inefficiency and may mean different things under each. In the case of market efficiency, the out-performance is generally explained by theexcess risk that value and small cap stocks face as a result of their higher cost of capital and greater business risk. However, in the case of market inefficiency, the out-performance can be explained by market participants arriving at the incorrect value of these companies. This results in excess return in the long run as the value adjusts.
