Capital Asset Pricing Model and Fama−French Model

Investors want to be compensated for taking higher risk by a higher expected return. This raises the question of the level of return compensation. In financial market theory, this question is answered by one-factor and multifactor models which determine the expected return of a single asset or a portfolio of assets with one or more systematic risk factors. The most widely used model is probably the capital asset pricing model (CAPM). With this one-factor model, which is typically applied to equity securities, the expected return of a stock or stock portfolio is calculated by adding a risk premium to the risk-free rate. The former is the product of the expected equity market risk premium and the beta of the investment. The higher (lower) the systematic risk or market risk of the investment, the higher (lower) the beta and hence the expected return. However, empirical studies on equity securities demonstrate that stock returns are correlated not only with equity market returns but also with other factors. Two of these risk factors are the size of the firm (measured by market capitalisation) and the book-to-price ratio, which were captured by Eugène Fama and Kenneth French in a multifactor model. The Fama–French model (FFM) is a three-factor model that explains expected returns in terms of risk premiums and the corresponding betas for market, size, and value. Both the CAPM and the FFM are based on the assumption that investors are compensated by a premium when they assume systematic risk. Hence, only systematic risk is relevant to valuation. These two models differ in how systematic risk is measured. In the CAPM, the systematic risk is given by the market portfolio, whereas the FFM uses size and value as systematic risk factors in addition to the market portfolio. This chapter examines these two models.