FIN 614: Financial Management Larry Schrenk, Instructor

1.Multi-Factor Models 2.Fama-French Model 3.Pros and Cons

CAPM: One Factor Model Market Risk Other Possible Factors Inflation Interest Rates

Three Factor Model Market Risk Premium (Same as CAPM) Size (SMB) Book-to-Market Ratio (HML) Empirical, not Theoretical

Small Firms Generating Higher Return Not captured by CAPM Small Minus Big (SMB): Return on Small-Cap Stocks ─ Return on Large-Cap Stocks

High Book-to-Market Firms Generating Higher Return Not captured by CAPM High Minus Low (HML): Return on High B/M Stocks ─ Return on Low B/M Stocks

E(r i ) = r f +  i E(r M – r f ) +  ’ i E(SMB) +  ’’ i E(HML) r f = Risk Free Rate r M = Return on Market  i = Regression Coefficients SMB = Small minus Big Size HML = High minus Low M/B

Pros: Empirical Support for Improved Performance Explains a Greater Proportion of the Non- Diversifiable Volatility Cons: Not Based on Theory Factors are Highly Volatile What Do SMB and HML ‘Capture’? Adding any Variable to a Regression Increases R- Squared

FIN 614: Financial Management Larry Schrenk, Instructor