Factorbased Asset Pricing Models
FamaFrench 3factor asset pricing model
The asset pricing model, developed by Eugene Fama and Kenneth French, is widely accepted as one of the most successful Factorbased AssetPricing Models ever created. Derived with empirical arguments in mind,
FamaFrench model provides much better fit to real data then popular CAPM.
FamaFrench 3factor assetpricing model corresponds to the following 3factor regression (for further notations look in Factorbased AssetPricing Models):
Three factor portfolios that enter the above equation have the following financial meaning:
 M represents market portfolio — the same factor that appears in CAPM.
 SMB (Small Minus Big) portfolio represents zeroinvestment portfolio that is long in smallcap stocks and short in bigcap stocks.
 HML (High Minus Low) portfolio represents zeroinvestment portfolio that is long in high booktomarket stocks (socalled “Value” stocks) and short in low booktomarket stocks (socalled “Growth” stocks).
FamaFrench model is based on the observation that small cap stocks and “Value” stocks historically tend to do better than market as a whole. A very natural way to formalize this empirical fact is to write down the above regression equation. While statistics for CAPM usually takes values of around . 0 85, FamaFrench model is capable of accounting for almost all variation in individual assets.
Note. The reason why FamaFrench model is so successful in fitting stock data is far form being obvious. One of intuitively appealing explanations is that SMB and HML portfolios serve as “correction factors” for a broadbased index, commonly used as market portfolio. Since broad index puts more weight in bigcap and “growth” stocks rather than in smallcaps and “value” stocks respectively, it may lead to some bias between broadbased index and practically unobservable market portfolio. It is quite possible that SMB and HML portfolios simply “correct” the broad index for the mentioned effect.
The historical data for SMB and HML portfolios can be downloaded from Kenneth French’s website.
 
