The Fama-French three-factor model does not include the difference in expected returns of high-beta stocks minus small-beta stocks as a factor. The model was developed by Eugene Fama and Kenneth French to better predict the returns of stocks and portfolios. It expands on the capital asset pricing model (CAPM) by adding two additional factors: size and value. The size factor is the difference in returns between small and large stocks, while the value factor is the difference in returns between high and low book-to-market stocks. Beta, a measure of a stock's volatility in relation to the market, is not a factor in the Fama-French model. While beta is used in the CAPM to measure market risk, Fama and French found that size and value factors provide a better explanation of stock returns.

Choice A is incorrect. The market factor, which is the excess return of the market portfolio over the risk-free rate, is indeed a part of the Fama-French three-factor model. This factor represents systematic or non-diversifiable risk.

Choice C is incorrect. The difference in expected returns between high book-to-market stocks and low book-to-market stocks, also known as value premium, is another factor in this model. High book-to-market stocks are considered undervalued or "value" stocks and tend to have higher returns than low book-to-market (growth) stocks.

Choice D is incorrect. The difference in expected returns between small-cap and large-cap companies, also known as size premium, forms the third factor of this model. Small companies tend to have higher risk and therefore higher expected returns compared to large companies.

Things to Remember

• The Fama-French three-factor model is an asset pricing model that adds two additional factors (size and value) to the traditional CAPM model.