Video Transcript: Fama-French Three Factor Model

hello, welcome. We're going to discuss the fama French three factor model. So  remember the capital asset pricing model that we covered before, where our  return for a single security is the risk free rate plus beta times the market return  minus the risk free rate. Okay, that is one component of the fama French three  factor model. CAPM, so let's look at this chart, portfolio of stocks with similar  betas. After forming portfolios of stocks with similar betas, the subsequent  portfolio returns are observed and shown in the following plot. Remember, one  is the beta for the market. One represents the beta for the market. Notice how,  as the beta grows, so does the average return. So notice the far right, the top  1.6 beta, it has an average return of two, and as we move closer to one, you'll  notice that the average return goes down. So the beta over one shows that it's a greater risk than the market, or more volatility than the market, and as you move closer to one, you'll see that the return is diminishing because you're assuming  less risk. So CAPM linear function of beta after forming portfolio of stocks and  similar betas, the subsequent portfolio returns are observed and shown in this  plot. CAPM says the expected return is positive and it's a linear function of beta.  This plot of actual data shows a positive linear relation, so the model seems to  work. Notice how we have a linear correlation between beta and return. But  CAPM says that beta is the only assets specific factor that you need to know to  estimate expected return. Other factors should add no value and expecting and  estimating expected return. So the lower plot adjust returns for the effects of size and book to market of the equity, so the book to market, so we have a book  price that is typically owner's equity, and that's going to represent our market  capital capitalization. So our market capitalization will be our stock price times  the number of shares outstanding. So our book price can be different than our  market price of our equity. So our book price is going to be the owner's equity,  whereas the market equity is the stock price times the number of shares  outstanding. So you're going to see the returns in these charts that are taking  the book value, and we're going to mark to market. So we're going to make sure that we are plotting these returns based on the market value, not the book value of our equity. After these factors are taken into account, there seems to be no  relation between expected return and beta. The positive linear relationship is  gone. If you look at the lower chart, when we price from book to market. So here is the factor, the three factor model, the FAMU French three factor model. Notice we have the risk free plus the beta market, then we'll have the market risk  premium, plus now you'll notice SMB and HML factors. These are computed  using six portfolios formed using size and book to market. So SMB stands for  small minus big. It is the return to a portfolio of small cap stocks, less the return  to a portfolio of large cap stocks. So we have small cap stocks under ten million  in market cap. So then you'll have large cap stocks that are over ten billion in  market cap. So you're going to subtract out the return to a portfolio of small cap  stocks against the return to a portfolio of large cap stocks. A lot of times, small 

cap stocks will have the greater return. Remember how we said before the small cap stocks, the smaller companies, they can stay more lean, more flexible,  control their costs, where larger companies, large cap stock companies, they  can times, be bloated, have excess costs therefore Have diminishing returns, so we'll subtract the large cap from the small cap to give us the SMB number. So  now we have the HML or the high minus low. This is the return to a portfolio of  stocks with high ratios of book to market values, less the return to a portfolio of  low book to market value stocks. So as you work this equation, it's a simple  equation to work. You subtract out the high or the large cap stock return from the small cap stock return, and in HML, you subtract out the return to portfolio  stocks with high ratios of book to market value and subtract out the portfolio of  low book to market value stocks for HML, simply add these together and you've  got your return.