Capital Asset Pricing Model
A formula for calculating the expected return of a security based on its systematic risk. This return is also called the “cost of equity capital”.
ri = rf + Bi(rm-rf)
Expected Return = Risk Free Return + Beta × Market Risk Premium
Risk Free Return: E.g. 3-month treasury bond is 1.25%
Security Beta: Volatility of returns relative to the entire market. Measure for security risk.
Market Risk Premium: Expected Market Return − Risk Free Return
Higher Systematic Risk(Bi↑) → Higher Expected Return(ri↑)
Fama French Three Factor Model
Add two factors (alpha > 0) to CAPM model. These two factors are cap size and stocks type.
Cap Size (summarized in Beta of “Small Minus Big”): Stocks with smaller market capitalization tend to outperform the stocks with larger market capitalization.
Stocks Type (summarized in Beta of “High Minus Low”): value stocks (companies with higher book-to-market ratio) outperform growth stocks (companies with lower BTM).
ri = rf + Bi(rm-rf) + B_SMB + B_HML
B_SMB: long on portfolio with small cap stocks, short on portfolio with large cap stocks
B_HML: long on portfolio with high BTM stocks, short on portfolio with low BTM stocks