The FamaFrench three-factor model is a linear model

designed by Eugene Fama and Kenneth French to

describe stock returns.
Explain the purpose of each factor of the Fama-French model

KEY POINTS[
The Fama-French model explains the return of a stock (r) through the risk free
rate (Rf), the market return (Km), and small market capitalization minus big (SMB),
and high book-to-market ratio minus low (HML).
Both SMB and HML measure the historic excess returns of small caps over big caps
and of value stocks over growth stocks, and can be looked up online.
The Fama-French has been shown to explain 90% of the returns of a
diversified portfolio, while CAPM explains only 70%.

The FamaFrench three-factor model is a model designed by Eugene Fama and

Kenneth French to describe stock returns . Like CAPM and the Arbitrage Pricing Theory,
the Fama-French three-factor model is a linear model that relates structural factors to
the expected return of an asset. Unlike those two models, however, the Fama-French
model has three specific and defined factors.

Eugene Fama Winning an Award

Eugene Fama (left) designed the Fama-French model with Kenneth French.
The result is the following model:

The Fama-French model tries to explain the return of a stock (r) through the risk
free rate (Rf), the market return (Km), and small market capitalization minus big (SMB),
and high book-to-market ratio minus low (HML). Beta, bs, and bv are coefficients, and
alpha is an error term.

Both SMB and HML measure the historic excess returns of small caps over big
caps and of value stocks over growth stocks. These factors are calculated with
combinations of portfolios composed by ranked stocks and available historical market
data, and are listed online for easy reference.

Research shows that SMB and HML, are country specific, meaning that they must
be calculated for the specific country and market in which the company is located and
listed. That is not to say that global factors are not influential in determining the return of
an asset, but rather, that for a three-factor model, the return of an equity is better
explained using local factors.

Though it is more complex than CAPM, the Fama-French model has been shown
to be a better at explaining the returns of a diversified portfolio: CAPM explains 70% of
returns on average, while the Fama-French model explains 90% on average.

Source: Boundless. Fama-French Three-Factor Model. Boundless, 20 May. 2016. Retrieved 24 May.
2016 from https://www.boundless.com/finance/concepts/fama-french-three-factor-model-0-11381/