Below is a second excerpt from the Level 2 Analyst Tricks CFA Cram guide. The first sample trick is dealing with nonparallel yield curve twists. The Analyst Trick guide aims to offer quick, easy to recall memory tricks for CFA concepts that are otherwise easy to forget. Nothing is worse than getting to exam day, understanding the concept being tested, but completely blanking while trying to recall the precise term, definition, or formula. Analyst Tricks aims to alleviate this tendency on the CFA!
The sample below aims to help you remember exactly what Fama French is dealing with. It’s a very simple concept everyone should know, but if it’s not a term you work with day-in-day-out, it’s easy to forget which factor Fama French adds on.
Fama French Sized Fries
The Fama-French is a simple multi-factor model that tries to account for the higher stock market returns for small cap stocks. It does so by adding a market cap size factor on top of CAPM.
- Fama-French solves for a stock’s required return
- The 3 parts of Fama-French:
- Market Premium, Market Cap spread, and Book Value
The Memory Trick
Most European and French sized food portions are a lot smaller than American portions
- This is even true for FrenchFries!Thus, Fama French addresses Small sized caps.
- Small Cap size is a premium.A luxury.Like many French goods are premium quality.
- French is Book Value. The French archetype is ‘sophisticated’.Sophisticated French men like to read books and think and other stuff 😉
- Return = Risk Free Rate
- + Market Premium: = β(Return on val weighted index – RFR)
- + Cap size: = β(Avg Return small caps – Avg Return large caps)
- + Book Value: = β(Avg Return high book value – Avg Return low book value)