Page 313 - DCOM504_SECURITY_ANALYSIS_AND_PORTFOLIO_MANAGEMENT

Security Analysis and Portfolio Management

Notes The original CAPM equation:
E(r ) = r + A (E(r ) - r )
A (f) m (f)
where, r is the risk-free rate and
(f)
E(r ) is the expected excess return of the market portfolio beyond the risk-free rate, often
m
called the equity risk premium.
The Fama and French equation:
E(r ) = r + A (E(r ) - (r ) + s SMB + h HML
A (f) m f A A
where, SMB is the “Small Minus Big” market capitalization risk factor and
HML is the “High Minus Low” value premium risk factor
SMB, Small Minus Big, measures the additional return investors have historically received by
investing in stocks of companies with relatively small market capitalization. This additional
return is often referred to as the “size premium.”
HML, which is short for High Minus Low, has been constructed to measure the “value premium”
provided to investors for investing in companies with high book-to-market values (essentially,
the value placed on the company by accountants as a ratio relative to the value the public
markets placed on the company, commonly expressed as B/M). (Note terminology usage as mentioned
above.)
The key point of the model is that it allows investors to weight their portfolios so that they have
greater or lesser exposure to each of the specific risk factors, and therefore can target more
precisely different levels of expected return.
Market risk is a common factor, so it does not appear on the graph. Note that although there are
three factors in the model, only two are ever shown. Now this is one very common reason for
this model to be known as a two factor model.

Figure 12.2: Three-factor Model: Risk Axes

HML

SMB

12.4 Multi Factor Model

A Multi Factor Model can be defined as a financial model that employs multiple factors in its
computations to explain market phenomena and/or equilibrium asset prices. The multi-factor
model can be used to explain either an individual security or a portfolio of securities. It will do
this by comparing two or more factors to analyze relationships between variables and the
security’s resulting performance.

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