Financial Risk Manager Part 1
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The CAPM explains asset returns based on a single factor: market risk (beta). The Fama-French three-factor model builds upon the CAPM by adding two additional factors: SMB (Small Minus Big) and HML (High Minus Low). SMB captures the historical outperformance of small-cap stocks relative to large-cap stocks, while HML captures the historical outperformance of value stocks (high book-to-market ratio) relative to growth stocks (low book-to-market ratio). By incorporating these factors, the Fama-French model aims to provide a more comprehensive explanation of asset returns, particularly for portfolios with significant exposure to small-cap and value stocks.
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Explanation:
The correct answer is C. The Fama-French three-factor model extends the CAPM by adding two additional factors:
- SMB (Small Minus Big): Captures the size premium - the historical tendency of small-cap stocks to outperform large-cap stocks
- HML (High Minus Low): Captures the value premium - the historical tendency of value stocks (high book-to-market ratio) to outperform growth stocks (low book-to-market ratio)
These factors help explain asset returns more comprehensively than the single-factor CAPM, particularly for portfolios with significant exposure to small-cap and value stocks.
Why other options are incorrect:
- A & B: Incorrect because the Fama-French model does not explicitly incorporate macroeconomic variables
- D: Incorrect because the model does not include sector-specific factors; it focuses on size and value characteristics
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