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CA Final · Advanced Financial Management · Portfolio Management

In a Fama-French style three-factor model, which set of factors is used to explain portfolio returns?

The Fama-French three-factor model uses market excess return, a size factor (small minus big) and a value factor (high minus low book-to-market ratio). Momentum was added later in the Carhart four-factor model, and macroeconomic variables belong to APT-style models.

  1. AMarket excess return, size (small minus big) and value (high minus low book-to-market)Correct
  2. BMarket excess return, inflation and industrial production
  3. CMarket excess return, momentum and liquidity
  4. DInterest rate, exchange rate and GDP growth

Explanation

The Fama-French three-factor model augments the market excess return factor with SMB (size) and HML (value) factors. The other sets contain macroeconomic or other factors not part of the three-factor model, such as momentum, which belongs to the later Carhart four-factor extension.

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