Fama and French Three Factor Model

The Fama and French Three Factor Model is a model that describes the relationship between stock returns and various risk factors. The model was developed by Eugene Fama and Kenneth French in 1993.

The model is based on the idea that stock returns are not just determined by the risk of the stock itself, but also by the risk of the market as a whole and by the risk of the size and value of the company.

The model includes three factors:

* Market risk: This is the risk that the market as a whole will go up or down.
* Size risk: This is the risk that small companies will do worse than large companies.
* Value risk: This is the risk that value stocks (stocks with low price-to-earnings ratios) will do worse than growth stocks (stocks with high price-to-earnings ratios).

The model predicts that the returns on a stock will be a function of these three factors. The model has been shown to be a good predictor of stock returns, and it is often used by investors to make investment decisions.

One of the key insights of the Fama and French Three Factor Model is that the market is not efficient. This means that it is possible to earn excess returns by investing in stocks that are undervalued by the market. The model identifies two factors that can be used to identify undervalued stocks: size and value.

Small stocks are typically more volatile than large stocks, and they tend to do worse during economic downturns. However, they also tend to do better during economic expansions. Value stocks are stocks with low price-to-earnings ratios. They are typically considered to be more risky than growth stocks, but they also tend to have higher returns.

The Fama and French Three Factor Model has been used by investors for many years to make investment decisions. It is a valuable tool for understanding the relationship between stock returns and risk factors.