Question

1. Compare and contrast the Capital Asset Pricing Model and the Fama-French three-factor asset pricing models. Be sure to include the similarities, the differences, and why each could be considered superior to the other. Conclude by explaining which you feel is a more effective way to assess if a specific security (or set of securities) is fairly valued.

Answer 1

The Fama-French three factor model (FF3FM) is an extension of the Capital Asset Pricing Model(CAPM).

According to CAPM equation, a linear relationship exists between required return of a stock and its systematic risk known as beta.This single factor syatematic risk is innately simple to interpret and is the central piece of this austere model.Whereas FF3FM aims to describe stock returns through three factors;

a)Market Risk

b)The outperformance of small-cap companies relative to large-cap companies

c)The outperformance of high book to market value companies versus low book to market value companies.

The FF3FM is adjusted for outperformance tendencies.Also,two extra risk factors make the model more flexible relative to CAPM.

The FF3FM is much more complex than CAPM and it takes more time to compute as well.

The CAPM pioneered the way in which assets are priced,however it is encumbered with several limitations.For example,the model makes a series of unrealistic assumptions and may be inadequate representation of of the behaviour of financial markets.

The above-mentioned consideration suggest that the single factor CAPM is not entirely suitable for security valuation.Thus if we have the time and effort required to use the FF3FM,the FF3FM is more effective.