What are the Fama French 4 factor models?
The Fama-French factor model, a widely used asset pricing model. That explains the returns of a portfolio or an individual asset based on three factors: market risk, size, and value! Developed by Eugene Fama and Kenneth French in their 1992 paper “The Cross-Section of Expected Stock Returns.” And has since become a cornerstone of empirical asset pricing research.
The three factors in the Fama-French model are:
- Market risk: This factor represents the excess return of the overall stock market. Captured by the difference between the return on a market index (such as the S&P 500) and the risk-free rate.
- Size: This factor represents the difference in returns between small and large companies. Captured by the difference in returns between a portfolio of small companies (usually the bottom 10% of the market by market capitalization) and a portfolio of large companies (usually the top 10%).
- Value: This factor represents the difference in returns between stocks with high book-to-market ratios (value stocks) and stocks with low book-to-market ratios (growth stocks). Captured by the difference in returns between a portfolio of high book-to-market stocks (usually the top 30%) and a portfolio of low book-to-market stocks (usually the bottom 30%).
The Fama-French model suggests that the excess returns of a portfolio or asset can become explained by exposure to these three factors. Specifically, a higher exposure to market risk, smaller size, and higher book-to-market ratio (value) should lead to higher expected returns. The Fama-French model has shown to provide a better explanation of asset returns than traditional CAPM (Capital Asset Pricing Model) which only accounts for market risk.
What are the Fama French 4 factor models?
The Fama-French four-factor model is an extension of the Fama-French three-factor model that adds a fourth factor, profitability. The model was proposed by Eugene Fama and Kenneth French in their 2015 paper, “A Five-Factor Asset Pricing Model,” and has become a widely used asset pricing model in empirical finance research.
The four factors in the Fama-French four-factor model are:
- Market risk: This factor is the same as in the Fama-French three-factor model, representing the excess return of the overall stock market.
- Size: This factor is also the same as in the Fama-French three-factor model, representing the difference in returns between small and large companies.
- Value: This factor is also the same as in the Fama-French three-factor model, representing the difference in returns between value and growth stocks.
- Profitability: This factor represents the difference in returns between companies with high profitability (measured as operating income-to-book equity) and companies moreover, with low profitability. It is captured by the difference in returns between a portfolio of high profitability stocks (usually the top 30%) in addition a portfolio of low profitability stocks (usually the bottom 30%).
The Fama-French four-factor model suggests that the excess returns of a portfolio or asset can become explained by exposure to these four factors.
Moreover, specifically, a higher exposure to market risk, smaller size, higher book-to-market ratio (value). In addition, higher profitability should lead to higher expected returns. The addition of the profitability factor has been shown to improve the explanatory power of the model. And provide a better explanation of asset returns compared to the Fama-French three-factor model.
What are the Fama French 4 factor models?
