The three-factor model was developed by Fama and French in 1992. It is a multi-factor model that includes the variables for firm size, book-to-market values and excessive returns on the market.
The three-factor model tries to estimate the returns of a stock based on the size of the firm, its book-to-market value and its return on the market (the return of the stock minus the risk-free rates).
They developed the model on the idea that smaller companies tend to deliver larger returns on the market than larger companies, with smaller companies also having a lower book-to-market value.
The formula is: Rit − Rft= αit + β1(RMt−Rft) + β2SMBt + β3HMLt + ϵit.
Where.. Rit = total return of a stock or portfolio i at time t
Rft = risk free rate of return at time t
RMt = total market portfolio return at time t
Rit−Rft = expected excess return
RMt−Rft = excess return on the market portfolio (index)
SMBt = size premium (small minus big)
HMLt = value premium (high minus low)
β1,2,3 = factor coefficients
Copyright © 2021 Methodology