Lecture 6 - Factor Discussion.pptx

Lecture 6 - Factor Discussion.pptx - Fama-French...

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Unformatted text preview: Fama-French ThreeFactor Analysis Learning Objectives • Describe the Fama-French three-factor model • Build a regression model in Excel • Analyze how well an asset’s returns are explained by the Fama-French three-factor model From a Single to MultiFactor ModelR = asset return i • The traditional regression model for analyzing excess returns is the Capital Asset Pricing Model (CAPM), a single-factor model: (� �−� �) = � � + � � (� ��� −� �) + ei • The model stipulates there is only one risk factor: the return on the market portfolio. Rf = risk-free rate of return �i = difference between the asset’s return and the expected return βi = measure of the asset’s systematic risk in relation to the market RMKT = the market return ei = random error/non-systematic risk From a Single to MultiFactor Model (cont.) • According to the CAPM theory, in the previous slide’s equation, � (alpha) should equal 0. However, that is not always the case. • Researchers began investigating models where additional factors (e.g. interest rates) could be added to the market factor in order to better explain excess returns. • Analyzing historical data, Eugene Fama and Kenneth French noticed that small-cap stocks and value stocks tended to outperform large-cap stocks and growth stocks. Fama-French ThreeFactor Model • Fama and French added a size factor and a value factor to the market factor: (� �−� �) = � � + � � (� ���−� �)+ si(SMB) + hi(HML) + ei • Empirically, their three-factor model explained historical returns better than the single-factor market model, explaining over 90% of excess returns as opposed to approximately 70%. Size: (SMB) Small Minus Big (� �−� �) = � � + � � (� ���−� �)+ si(SMB) + hi(HML) + ei • The size premium (SMB) is the average monthly return on the smallest 30% of stocks (in terms of market capitalization) minus the average monthly return on the largest 30%. • When small stocks do well relative to large stocks, this will be positive; when they do worse than large stocks, this will be negative. Value: (HML) High Minus Low (� −� ) = � + � (� −� )+ s (SMB) + h (HML) + e � � � � ��� � i i i • The value premium (HML) is the average monthly return for the 50% of stocks with the highest book-to-market ratio minus the average return for the 50% of stocks with the lowest book-to-market ratio. • When high value stocks do well relative to low value stocks, this will be positive; when they do worse than low value stocks, this will be negative. • High book-to-market stocks are considered “value” stocks; low book-to-market stocks are considered “growth” stocks. Factor Betas • Extending the single factor CAPM model, the Fama-French model uses three factor betas: (� �−� �) = � � + � � (� ���−� �)+ si(SMB) + hi(HML) + ei • A factor beta (sometimes called a “factor loading”) is the sensitivity of security’s returns to a particular systematic factor. • With this model, market returns can roughly be explained by three factors: (1) exposure to the overall market (RMKT - Rf); (2) exposure to small cap stocks (SMB); and (3) exposure to value stocks (HML). The Fama-French Factors • Ken French publishes datasets of the Fama-French factors for distribution from his web site at Dartmouth University. • For more detailed information on how these factors were calculated, visit his web site at: a_library.html • As research continues, additional factors continue to be added to the original three-factor model. Assignment •Use a WRDS query to select and download historical monthly returns for two exchange-traded funds (ETFs). •The Fama-French three-factor data will be provided in this query’s output. Conclusion •In the Capital Asset Pricing Model, the market portfolio return is the sole source of risk. •The Fama-French three-factor model suggests that portfolio returns can roughly be explained by three factors: (1) exposure to the broad market (RMKT - Rf) (2) exposure to small stocks (SMB) (3) exposure to value stocks (HML) •A factor beta represents the sensitivity of a portfolio’s returns to changes in a systematic factor. Notes (cont.) For Fama-French data: • Monthly returns on the market portfolio are value-weighted returns for all firms listed on the NYSE, AMEX, and NASDAQ. • The risk-free rate is the return on 1-month T-bills. • Additional information is available on Ken French’s web site: ndex.html ...
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