What is the purpose of the Fama-French three-factor (FF3) model? Pick ALL the right answers. E(R)=Alpha+Beta1*MKT+Beta2*SMB+Beta3*HML (1)
Question:
What is the purpose of the Fama-French three-factor (FF3) model? Pick ALL the right answers.
E(R)=Alpha+Beta1*MKT+Beta2*SMB+Beta3*HML
(1) The model can explain the return anomalies based on the size effect and the value effect. Specifically, regressing returns of a small stock portfolio or a large stock portfolio on the FF3 factors, one would observe almost zero alpha.
(2) Using the FF3 model, if one observe the alpha of the small stock portfolio is zero, then that means the small stock portfolio will apear fairly priced.
(3) Using the CAPM model, one would find that small stocks deliever a positive alpha. That is, regressing the small stock portfolio return on the MKT factor, one gets a positive alpha. However, using the FF3 model for small stocks, one would find a zero alpha. That means some of the small stock portfolio return can be explained by their exposures (betas) to the risk factors MKT, SMB, and HML. After acccounting for such risk-related returns (beta1*MKT, beta2*SMB, beta3*HML), there are no more remaining return left. Therefore, a zero alpha in the FF3 model means that small stocks appear not mispriced in the FF3 world. And market price for small stocks appear efficient in the FF3 world.
| A. | 1 and 2 | |
| B. | 2 and 3 | |
| C. | 1 | |
| D. | 1, 2, and 3 |
Expert Answer:
The purpose of the FamaFrench threefactor FF3 model is to provide a framework for explaining stock returns based on three factors market risk MKT size ... View the full answer
