Learning outcomes. After watching this video you will be able to describe commonly used risk factors briefly explain why they work. Commonly used risk factors. We have discussed multi-factor models and the APT. But what should these risk factors be? A number of researchers have proposed various risk factors, but the most popular of these are those put forth by Eugene Fama and Ken French in 1993. They proposed three risk factors which they call RMRF, SMB and HML. RMRF is the return on a market index minus the risk-free rate. SMB is Small Minus Big which is the return on a portfolio of small companies that is, companies with low market capitalization, minus the return on a portfolio of big companies, that is, companies with high market capitalization. HML is High Minus Low. Which is the return on a portfolio of high book to market ratio firms, minus a portfolio of low book to market ratio companies. RMRF essentially captures the systematic risk of the market index. The systematic risk originates from macroeconomic factors. Fama and French argued that small firms are likely to be more sensitive to sudden changes in business conditions than big firms. And hence SMB is a factor. Firms with high values of book-to-market ratios are more likely to be in financial distress than those with low values and hence HML is a factor. To understand the HML factor better, let's first define what book-to-market ratio means. It is the ratio of a stocks book value to its market value. The book value comes from the firm's financial statements. The market value of equity is simply its current market capitalization. The ratio tells us what its book value is relative towards market value. While there are many ways of interpreting this ratio, we will look at one way of interpreting it in the context of the HML factor. If the ratio is low then it reflects the growth opportunities of the company. These growth opportunities are captured by a relatively higher market capitalization leading to a low value for the ratio. On the other hand, if the ratio is high, it reflects the company's bad financial health. Since the company isn't doing well, it's market value is low relative to its book value leading to a high ratio. One thing to note is that SMB and HML do not seem obvious choices for risk factors. But Fama and French provide empirical justifications to use them as risk factors. Thus, SMB and HML may capture sensitivity to unknown risk factors in the macro economy which is why they work well in explaining observed returns. A large body of research shows that the Fama French Three Factor Model works in markets all over the world, as well as over time. But the thing to note is that the model has worked well for the last 90 years or so. But there is no guarantee that it will work well for the next 50 or even 100 years. This is the problem with having empirical models rather than theoretical models like the Cap M or APT. In 1997, Mark Carhart added a fourth factor. One based on persistence in stock performance called the Momentum factor, MOM. This is the return on a portfolio of companies that have performed well in the recent past, called winners minus a return on a portfolio of companies that have performed badly in the recent past called losers. Recent winners continue to perform well whereas recent losers continue to perform badly. Historically, these four factors MRMF, SMB, HML and MOM explain over 80% of the variation in stock returns and hence they're commonly used risked factors in multi-factor models.