Recall that the CAPM has the following form:
Here, E() is the expectation, E(Ri) is the expected return for stock i, Rf is the risk-free rate, and E(Rmkt) is the expected market return. For instance, the S&P500 index could serve as a market index. The slope of the preceding equation (
) is a measure of the stock's market risk. To find out the value of , we run a linear regression. The Fama-French three-factor model could be viewed as a natural extension of CAPM, see here:
The definitions of Ri, Rf, and Rmkt remain the same. SMB is the portfolio returns of small stocks minus the portfolio returns of big stocks; HML is the portfolio returns for high book-to-market value minus returns of low book-to-market value stocks. The Fama/French factors are constructed using the six value-weight portfolios formed on size and book-to-market. Small Minus Big (SMB) is the average return on the three small portfolios minus the average return on the three big portfolios. Based...
