Fama And French Three Factor Model
Categories: Financial Theory
Is it a bird? A plane? No...it’s an asset pricing model.
The Fama and French Three Factor Model is an asset pricing model built off of the back of the theoretical "capital asset pricing model." or CAPM. CAPM helps investors balance their portfolios by giving a theoretically desired rate of return for an asset, trying to predict reasonable future returns.
The Fama and French Three Factor Model brings CAPM to reality by adding in important reality ingredients, namely risk and risk factors. The Fama and French Three Factor Model also takes into account the fact that small-cap and value stocks generally perform better than other asset types.
Why the weird name? Nobel Laureate Eugene Fama and researcher Kenneth French, who used to teach at the University of Chicago’s business school, came up with this three-factor model…the three factors being: market risk, company size, and value factors, things that weight portfolio performance one way or another that’s not captured in the purely theoretical CAPM model.