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FRM Part I · FRM Exam Part I · The Arbitrage Pricing Theory and Multifactor Models of Risk and Return

In the Fama-French three-factor model, the SMB factor is constructed as the return on a portfolio of:

SMB, Small Minus Big, is the return on a portfolio of small-capitalization stocks minus the return on a portfolio of large-capitalization stocks. It captures the size premium. HML is the value factor and momentum and profitability are separate factors.

  1. ASmall-capitalization stocks minus large-capitalization stocksCorrect
  2. BStocks with low book-to-market ratios minus stocks with high book-to-market ratios
  3. CWinning stocks minus losing stocks over the past twelve months
  4. DHigh-profitability stocks minus low-profitability stocks

Explanation

SMB stands for Small Minus Big and is the return of small-cap stocks less that of large-cap stocks, capturing the size premium. Option B is the reverse of HML, C describes momentum (UMD/WML), and D describes the profitability factor (RMW) of the five-factor model.

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