[Santo AshokParticipant]

An Analyst is estimating the required return on equity for a company and has gathered the following information:

Estimated risk free rate (10-year government bond) – 6%

Estimated Equity market

An Analyst is estimating the required return on equity for a company and has gathered the following information:

Estimated risk free rate (10-year government bond) – 6%

Estimated Equity market return – 10%

Estimated ERP Beta – 0.8

Estimated SMB premium  – 5%

Estimated HML Premium – 2%

Intercept – 0.01

Coefficient on market factor – 0.75

Coefficient on SMB factor – 0.15

Coefficient on HML factor – 0.05

The Fama-French 3 factor model coefficients were estimated using the same risk free rate that is used in the CAPM

What is the required rate of return based on Fama-French Model

A. As per the CFA institute material the answer is 10.85% inclusive of intercept but in the formula mentioned in the material for 3 factor Fama-French model , intercept is not mentioned. It is mentioned as

Re= Rf+B*ERP+B*SMB+B*HML

Please explain on the same

 

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[Madhusudan Chandarasekaran, CFA, FRMKeymaster]

Hi Santosh, Thanks for asking this.

The difference is between the expected return and the actual or empirical estimate return.

While the Fama French 3 factor model is a conceptual model this interce

Hi Santosh, Thanks for asking this.

The difference is between the expected return and the actual or empirical estimate return.

While the Fama French 3 factor model is a conceptual model this intercept is the alpha (Think of as Jensen’s Alpha) that can be over or under the predicted or expected return. Since the question gives intercept or alpha, we are asked to assume the manager has that excess return on top of the three-factor model. Hence it is included while calculating the Required rate of return.  Hope this helps.

 

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