Question

Fama and French rationalise their SMB and HML factors as reflecting the extra riskiness of small stocks and low price-to-book value stocks respectively, is this explanation convincing?

Answer 1

SMB factors refer to the small size firm effect while HML refers to the High minus low book value effect. The SMB factors consider a certain level of risk premium for a small market capitalization company over a large market capitalization company to consider the effect of the different risk associated with the size of the company like less liquidity in the stock, information asymmetricity. The high in the HML factor refers to the high book value to the market value ratio and low refers to the low book value to the market value ratio. It is often seen that companies with high book value are considered to be value stocks and value stocks tend to do better more often. The low book value stocks are referred to as growth stock and the growth stocks are riskier because and value stocks perform better so these premiums are justifiable.