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Financial Economics, The Cross-Section of Stock Returns and the Fama-French Three Factor Model

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Encyclopedia of Complexity and Systems Science

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Definition of the Subject

Different stocks have different expected rates of return and many asset pricing models have been developed to understand why this is the case. According to such models, different assets earn different average returns because they differ in their exposures to systematic risk factors in the economy. Fama and French [12] derive a model in which the systematic risk factors are the market index, and two portfolios related to the size of a company, and its ratio of book value to market value (book-to‐market). The size and book-to‐market factors are empirically motivated by the observation that small stocks and stocks with high book-to‐market ratios (value stocks) earn higher average returns than justified by their exposures to market risk (beta) alone. These observations suggest that size and book-to‐market may be proxies for exposures to sources of systematic risk different from the market return.

Introduction

An important class of asset pricing models in finance...

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Notes

  1. 1.

    The estimate of the market risk premium tends to be negative. This result is consistent with previous results reported in the literature. Fama and French [11], Jagannathan and Wang [18], and Lettau and Ludvigson [24] report negative estimates for the market risk premium, using monthly or quarterly data.

  2. 2.

    The following is only a partial list of papers that document time‐variation in the excess market return and the variables they use: Campbell [2], term spread; Campbell and Shiller [4], dividend yield; Fama and Schwert [16], T-bill rate; Fama and French [10], default spread.

Abbreviations

Market capitalization :

Market capitalization is a measure of the size of a public company. It is equal to the share price times the number of shares outstanding. Small stocks have small market capitalizations, while large stocks have large market capitalizations.

Book-to‐market ratio :

A ratio used to compare a company's book value to its market capitalization value. It is calculated by dividing the latest book value by the latest market value of the company.

Value stocks :

Value stocks tend to trade at lower prices relative to fundamentals like dividends, earnings, sales and others. These stocks are considered undervalued by value investors. Value stocks usually have high dividend yields, and high book-to‐market ratios.

Growth stocks :

Growth stocks tend to trade at higher prices relative to fundamentals like dividends, earnings, sales and others. Growth stocks usually do not pay dividends and have low book-to‐market ratios.

Market beta :

The market beta is a measure of the systematic risk of a security in comparison to the market as a whole. It measures the tendency of the security return to respond to market movements.

Capital asset pricing model (CAPM) :

The CAPM describes the relationship between risk and expected return and it is used in the pricing of risky securities. According to the CAPM, the expected return of a security equals the rate on a risk-free security plus a risk premium that increases in the security's market beta.

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Authors and Affiliations

  1. Mays Business School, Texas A&M University, College Station, USA

    Ralitsa Petkova

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  1. RAMTECH LIMITED, 122 Escalle Lane, Larkspur, CA, 94939, USA

    Robert A. Meyers Ph. D. (Editor-in-Chief) (Editor-in-Chief)

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Petkova, R. (2009). Financial Economics, The Cross-Section of Stock Returns and the Fama-French Three Factor Model. In: Meyers, R. (eds) Encyclopedia of Complexity and Systems Science. Springer, New York, NY. https://doi.org/10.1007/978-0-387-30440-3_203

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