CAPM vs. Three Factor Models

Attribute	CAPM	Three Factor Models
Number of factors	1	3
Market risk	Systematic risk	Systematic risk
Factors considered	Market return	Market return, size, value
Assumptions	Market efficiency, risk-free rate	Market efficiency, risk-free rate, size and value premiums

Introduction

When it comes to evaluating the risk and return of an investment, two popular models that are often used are the Capital Asset Pricing Model (CAPM) and the Three Factor Model. Both models have their own set of attributes and assumptions that make them unique in their approach to understanding the relationship between risk and return in the financial markets.

Capital Asset Pricing Model (CAPM)

The Capital Asset Pricing Model (CAPM) is a widely used model in finance that describes the relationship between risk and expected return of an investment. According to CAPM, the expected return of an investment is equal to the risk-free rate plus a risk premium that is proportional to the beta of the investment. Beta measures the sensitivity of an investment's returns to the overall market returns. CAPM assumes that investors are rational and risk-averse, and that they can diversify away unsystematic risk.

Three Factor Model

The Three Factor Model, developed by Eugene Fama and Kenneth French, is an extension of the CAPM that takes into account additional factors that can explain the variation in stock returns. The three factors in this model are market risk, size risk, and value risk. Market risk is the same as in CAPM, but size risk and value risk are new factors that capture the additional risk associated with small-cap stocks and value stocks, respectively. The Three Factor Model argues that these factors are better at explaining the cross-section of stock returns than beta alone.

Assumptions

• CAPM assumes that investors are rational and risk-averse, while the Three Factor Model does not make any specific assumptions about investor behavior.
• CAPM assumes that investors can diversify away unsystematic risk, while the Three Factor Model incorporates additional factors that capture specific sources of risk.
• CAPM assumes that the market portfolio is mean-variance efficient, while the Three Factor Model does not rely on this assumption.

Factors Considered

One of the key differences between CAPM and the Three Factor Model is the factors that are considered in each model. CAPM only considers market risk, which is captured by the beta of an investment. On the other hand, the Three Factor Model considers market risk, size risk, and value risk. This means that the Three Factor Model takes into account additional sources of risk that can affect the returns of an investment.

Empirical Evidence

Empirical studies have shown mixed results when comparing the performance of CAPM and the Three Factor Model. Some studies have found that the Three Factor Model provides a better explanation of stock returns than CAPM, especially when looking at small-cap and value stocks. Other studies have found that CAPM still holds up well in explaining the cross-section of stock returns. Overall, the empirical evidence suggests that the Three Factor Model may provide a more comprehensive framework for understanding the risk and return of investments.

Practical Applications

From a practical standpoint, both CAPM and the Three Factor Model are used by investors and financial analysts to estimate the expected return of an investment. CAPM is simpler to use and understand, as it only requires the beta of an investment to calculate the expected return. On the other hand, the Three Factor Model provides a more nuanced approach by considering additional factors that can impact stock returns. Depending on the specific characteristics of the investment being analyzed, either model may be more appropriate.

Conclusion

In conclusion, both CAPM and the Three Factor Model are valuable tools for understanding the relationship between risk and return in the financial markets. While CAPM is a simpler model that relies on the beta of an investment to estimate expected return, the Three Factor Model takes into account additional factors such as size and value risk. Empirical evidence suggests that the Three Factor Model may provide a more comprehensive framework for explaining stock returns, especially for small-cap and value stocks. Ultimately, the choice between CAPM and the Three Factor Model will depend on the specific characteristics of the investment being analyzed and the preferences of the investor or analyst.