Question

What do the results in Fama And French models say about the CAPM? How does the small firm affect come into your argument? Explain.

Answer 1

Fama-French expands on the standard CAPM pricing model. CAPM uses a single factor (beta) to describe the returns of a stock portfolio versus the market. Fama-French adds two more factors to include the impact of two important asset classes and their relative proportion in a given portfolio: 1) small cap stocks versus large cap and 2) low book-to-market ratio stocks versus high."The intuition of using it" The idea is that these two factors have outsized importance in determining if a portfolio will outperform the market as small caps and low book-to-market ratio stocks have outperformed historically. You can use Fama-French calculated for a set of hypothetical portfolios to get a sense of which portfolio may perform better. (Note: There is also a Fama-French 5 factor model which includes two more factors relating to fixed income instruments (bonds).