Explanation:
The correct answer is C.
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.
A is incorrect. While macroeconomic variables can influence asset returns, the Fama-French model does not explicitly incorporate them. It focuses on firm-specific characteristics (size and book-to-market) as proxies for systematic risk factors.
B is incorrect. The Fama-French model does not explicitly include macroeconomic variables; it focuses on firm size (SMB), book-to-market ratio (HML), and market risk (beta).
D is incorrect. The Fama-French model does not include sector-specific factors; its additional factors are related to size and value characteristics, not industry.
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Q.5319 An investment analyst is evaluating the performance of a portfolio of small-cap value stocks. They are considering using the Capital Asset Pricing Model (CAPM) and the Fama-French three-factor model to estimate the expected returns of these stocks. Recognizing that small-cap stocks and value stocks have historically outperformed the market, the analyst wants to understand how the Fama-French model might provide a different perspective compared to the CAPM. Which of the following statements correctly describes how the Fama-French three-factor model differs from the CAPM in estimating asset returns?
A
The Fama-French model incorporates macroeconomic variables, such as inflation and GDP growth, to capture systematic risks not accounted for in the CAPM, which relies solely on the market risk premium.
B
The Fama-French model estimates expected returns by incorporating the effects of macroeconomic variables, such as GDP growth and inflation, alongside market risk
C
The Fama-French model expands on the CAPM by adding factors related to firm size and book-to-market ratio to account for the historical outperformance of small-cap and value stocks.
D
The Fama-French model uses sector-specific risk factors, such as industry concentration or sector returns, in addition to market beta, to account for risks specific to certain industries
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