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Fama-French Three-Factor Model

portfolio theory
Definition
A model explaining stock returns through three factors: market risk, company size, and book-to-market value (value vs. growth).

Explanation

Eugene Fama and Kenneth French expanded CAPM in 1993 by adding two factors: SMB (Small Minus Big, capturing the small-cap premium) and HML (High Minus Low, capturing the value premium). The three-factor model explains approximately 90% of diversified portfolio returns, compared to about 70% for single-factor CAPM. Later extensions added momentum (Carhart four-factor, 1997) and profitability and investment (Fama-French five-factor, 2015). These models form the academic foundation of factor investing.

Formula

Ri - Rf = αi + β1(Rm-Rf) + β2(SMB) + β3(HML) + εi

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