a theoretical question: in the fama-french three factor model, we get required rate of return on equity from the following equation: R= Risk-free rate + b1 * market risk premium + b2 * small-cap return premium + b3 * value return premium. Here, b stands for factor beta. my question is: why is there a value return premium instead of a growth-return premium? as far as my little knowledge is concerned, value stocks are mature stocks, they have large cash flow and relatively lower risk profile. as the risk is low, why would i add a risk premium for that? plus, it also contradicts the second premium. small-cap firms are small-scale firms and thus are more risky than large-cap firms. so, in this case, we can add a risk premium for that. this is not consistent with the third term. plz, someone help.
The model found posiitve risk premia based on empirical analysis. However, theoretical framework does not assume that the risk premia have to be positive (for any factor for that matter).
wrong, The real answer is that no one gives a shit in July.
What CMLSML said, as far as the theoretical model goes.
But I agree with you that having a positive (empirical) b3 is a little surprising. I’d have said b3 should = 0 i.e. investors would demand the same premium for value or growth, for different reasons. For value, lower expectations of risk and return, and for growth, higher. I don’t know if Fama and French know “why” either.
While market and size factors can be conveniently understood as risk factors, the labeling of the third factor as a risk factor has spurred much debate. The traditional CAPM regression has an R^2 of about 70 %, meaning that market risk can explain around that percentage of variation in average stock returns. The FF model has a higher R^2 of around 80/90 %, meaning that the model can capture average returns much better than the market model. According to some researchers, the market tends to undervalue value-stocks and overvalue growth stocks. Other researchers think that this result is period dependent and find no value premium at all. After much kerfuffle, it appears that small stocks and value stocks provide premia that cannot be satisfactorily explained away. Are there risk elements in small/value stocks that investors see and for which they demand greater risk premia? Or is the existence of such premia the result of biased/irrational pricing (behavioural finance) in the market? Surely, if markets were textbook efficient, stocks that command premia on account of their size/value characterisitics would have been arbitraged away over time
In the Fama French context, the value premium more refers to companies that have had a significant decline in price and now trade at very low P/E or other fundamental ratios. Think more like GM or HP than Duke Energy.