Question

16. The Fama-French three-factor model

Consider the following two statements and identify which model each describes:

This model uses a single risk factor, the variability of the stock with respect to the market portfolio, to explain the required return on a security or portfolio.

Capital Asset Pricing Model

Fama-French three-factor model

This model is incorrect because the size effect it uses does not influence stock returns and the book-to-market value effect either is insignificant or is not a function of risk.

Capital Asset Pricing Model

Fama-French three-factor model

Pam, an analyst at Grotesque General (GG), models the stock of the company. Suppose that the risk-free rate rRFrRF = 6.5%, the required market return rMrM = 12.5%, the risk premium for small stocks rSMBrSMB = 3.2%, and the risk premium for value stocks rHMLrHML = 4.8%. Suppose also that Pam ran the regression for Grotesque General’s stock and estimated the following regression coefficients: aGGaGG = 0.00, bGGbGG = 0.9, cGGcGG = 0.2, and dGGdGG = 0.3. If Pam uses a Fama-French three-factor model, then which of the following values correctly reflects the stock’s required return?

3.18%

7.48%

17.94%

13.98%

Answer 1

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Answer:

1. Capital Asset pricing model uses single risk factor i.e. beta. It is used to explain the required return on a security or a portfolio. Hence the answer to the first question is Capital Asset Pricing model 2. Fama French Model is a three factor model that uses size and value factors in addition to the market risk factor of CAPM. However there is debate related to the size effect and the book-to-market value effect. Hence the second answer is Fama-French-three- factor model. Snipping Tool 3. Ri = Rf + Beta(mrkt) x Market risk premium + Beta(size) x Risk premium for small stocks + Beta(value) x Risk Premium for value stocks Here Beta(mrkt) =bGC = 0.9; Beta(size) =CGC = 0.2; Beta(value) =dGC = 0.3; Market risk premium = rM - rf = 6.5% +0.9*(12.5% - 6.5%) + 0.2*3.20% + 0.3*4.80% = 13.98%