1- Eugene Fama, Sr. (Nobel prize winner in economics) and Kenneth French publish
ID: 2817850 • Letter: 1
Question
1- Eugene Fama, Sr. (Nobel prize winner in economics) and Kenneth French published a paper in 1992, which over the past 23 years as easily been the most influential academic paper in the field of investments. What two risk factors did Fama and French identify in this paper, other than the basic risk of the market itself (“market risk”)? Describe these two risk factors.
2- What is the (Fama-French) “three-factor model”? Has the three-factor model been tested in both U.S. and overseas markets, and if so, what is the result?
3- Describe the “momentum effect” in your own words. Give an example, in your own words.
Explanation / Answer
1.The two risk factors identified in the paper were size risk and value risk.
Size Risk
It states that small cap companies are riskier and more volatile than large companies. But small cap companies have generated higher returns than big cap companies.
Value risk
Value companies are those with low earnings, growth rates, high dividend and low price in comparison to its book value. But value stocks have outperformed the performance of growth stocks.
2. Fama and French Three-Factor Model
The Fama and French three factor model was develop by University of Chicago Professors, Eugene Fama and Kenneth French.
The Fama and French three factor model is an extension of the Capital Asset Pricing Model (CAPM). It determines stock returns by three factors:
The model states that high value and small-cap stocks regularly outperform the markets.
Fama and French three factor model formula:
Expected Return=Risk free rate+ Market risk premium+ SMB+ HML
Market risk premium
Market risk premium is the difference between expected market return and the risk free rate.
SMB(Small minus Big)
Small minus big measures the excess of small cap company’s performance over that of big cap companies. It states that small cap companies perform better than large cap companies.
High Minus Low (HML)
High minus low measures the excess of company’s high book to market values over companies with low book to market value. It states that value companies perform better than growth companies.
The Fama and French three factor model has been tested in United states and in overseas markets. It was found that Fama and French factors are country specific and that local factors perform better than global factors.
3.Momentum Effect
In momentum effect, a stock performing well will continue performing well and a stock performing badly will continue performing badly.
An example would be that of a company announcing the launch of a new product. The stock price will increase and the increased trading of the company’s stock will further increase the stock price.
I hope that was helpful :)
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