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IAI Actuarial Core Principles · Economic Modelling · Capital Asset Pricing Model (CAPM)

Which empirical finding is most commonly cited as an anomaly that the single-factor CAPM fails to explain, motivating the Fama-French three-factor model?

Small-capitalisation stocks and high book-to-market (value) stocks have earned higher returns than their betas imply. The single-factor CAPM cannot explain this, so Fama and French added size and value factors to the market factor.

  1. AReturns on small-capitalisation and high book-to-market stocks exceed those predicted by beta aloneCorrect
  2. BBetas of all stocks equal exactly one in the long run
  3. CGovernment bond yields are always above equity returns
  4. DStock returns are perfectly normally distributed
  5. Investors hold only the risk-free asset

Explanation

Fama and French found that size and book-to-market value explain cross-sectional returns beyond market beta. They therefore added size (SMB) and value (HML) factors to the market factor. The other statements are not findings of this kind.

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