Question

Critically evaluate the advantages and drawbacks of using multi-factor models (such as Fama, French and Carhart’s) in asset pricing.

Answer 1

When we need to explain any security or a potfolio, then we make use of certain models. Those models are called as Multi factor models. It involves specific computation to understand the portfolio value.Multi factor models are usd in implementation of setting up portfolios, they can be catagorised in various ways such as Fundamental model, statistical model , etc. Now if we have to learn about the nbenefits we derive froom these models they can be found as follow.

1. the above average performavce of the portfolio is generally explained by the excess risk that value and small-cap stocks face as a result of their higher cost of capital and greater business risk. The Three factor uses the small minus big theory.

2. This model considers the fact that value and small-cap stocks outperform markets on a regular basis.

3. akong with use in building models of equilibrium security pricing, multifactor models are useful in risk management applications. These models give us a simple way to measure our exposure to various macroeconomic risks, and construct portfolios to hedge those risks.
4. Apart from their use in building models of equilibrium security pricing, multifactor models are useful in risk management applications.

5. These models give us a simple way to measure our exposure to various macroeconomic risks, and construct portfolios to hedge those risks like CAPM

Drawbacks:

1. On the other side CAPM is built on four major assumptions, including one that reflects an unrealistic real-world picture. This assumption, that investors can borrow and lend at a risk-free rate, is unattainable in reality. Therefore, the minimum required return line might actually be less steep (provide a lower return) than the model calculates.

2. FAMA french model - the performance is explained by market participants mispricing the value of these companies, which provides the excess return in the long run as the value adjusts.

3.Another issue is that these returns are backward-looking and may not be representative of future market returns.

4. While using capm we use risk free return i which we mostly choose the return from government securities which changes daily and there is a high volatily rate.