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Eugene Fama is a remarkable individual who is now a Robert R. McCormick Distinguished Service Professor of Finance at the University of Chicago Booth School of Business. He was ranked as the 9th most influential economist of all time in April 2019 based on his academic contributions. He shared the Nobel Memorial Prize in Economic Sciences jointly with Lars Peter Hanson and Robert Shiller.
His Doctoral supervisors were Nobel Prize winners Harry Roberts and Merton Miller; at the Booth School of Business at the University of Chicago, he was awarded his MBA and Ph.D. in finance and economics.
Even though all his grandparents were immigrants from Italy, Boston, Massachusetts, is Fama’s birthplace, and his parents are Francis and Angelina Fama. Eugene, an Athletic Hall of Fame honored awardee who attended the Maiden Catholic High School before earning his undergraduate degree in 1960 in Romance Languages magna cum laude when he pursued higher education at Tufts University, where he again became one of the top student-athletes at the school.
Benoit Mandelbrot influenced him and has spent much time teaching at the University of Chicago.
Who is the Father of Financial Management?
Dr. Eugen Fama was the father of financial management and father of modern finance, a professor at the University of Chicago, a founding board member of Dimensional Fund Advisors, and a Laureate of the Nobel Memorial Prize in Economics in 2013.
key achievements of Eugene Fama:
- Born in 1939, Fama is an American economist and Nobel Laureate.
- He is best known for his work on portfolio theory and asset pricing, both theoretical and empirical.
- Fama is often called the “Father of Modern Finance” for his contribution to financial economics.
- Fama earned his undergraduate degree from Tufts University in 1960 and his MBA and Ph.D. from the University of Chicago in 1963 and 1964, respectively.
- Fama has been a professor at the University of Chicago Booth School of Business for over 50 years, where he continues to teach and research.
- He was instrumental in the development of the theory of efficient markets. His doctoral thesis proposed the concept of the “efficient market hypothesis” (EMH), which posits that financial markets are always perfectly efficient, meaning that it’s impossible to achieve higher-than-average returns consistently.
- Fama has written two books and published several influential papers in economics and finance.
- Fama and Kenneth French devised the “Fama-French three-factor model” to predict stock returns better. This model considers market risk, company size, and value factors in its predictions.
- In 2013, Fama was awarded the Nobel Prize in Economics, which he shared with Lars Peter Hansen and Robert Shiller. The Nobel Committee recognized them for their empirical analysis of asset prices.
- Fama is a board member of Dimensional Fund Advisors, a firm that applies his academic findings to real-world investment solutions.
- He’s been recognized for his contributions to economics and finance with numerous awards and honorary degrees.
- His work has profoundly influenced how we understand, analyze, and predict financial markets, shaping many investment strategies and regulations.
Eugene Fama is the father of the efficient market hypothesis.
His very impressive Ph.D. thesis was published in the Journal of Business in January 1965, and in 1968 in Institutional Investor, it was entitled “The Behavior of Stock Market Prices” and concluded that stock returns were explainable with many different discount rates. It was later rewritten into a less technical article than Walks in Stock Market Prices”.
His work after that showed how time-varying discount rates could explain predictability in expected stock returns. Higher average returns during recessions can be explained by a systematic increase in risk aversion, which lowers prices and increases average returns. In 1969, Fama won the Nobel Memorial Prize in Economic Sciences, and in 2013,
Many influential persons have recognized another vital work that he did in 1969. It was an interesting article (written by several co-authors), “The Adjustment of Stock Prices to New Information.” He tried to analyze how stock prices respond to events using price data from the CRSP database; it was the first of many other published studies.
The Ph.D. thesis Fama did in 1965 has caused people to see him as the person with the voice of authority for the efficient market hypothesis. He also published an analysis of the behavior of stock market prices. He explained his ideas about the “fat tail distribution properties,” he implied that extreme movements were more common than predicted on Normality’s assumption.
In 1970, he proposed two concepts being used in efficient markets even now when he wrote an article entitled “Efficient Capital Markets.” The strong form, semi-strong form, and weak efficiency are the three types of efficiencies that Fama first proposed. The information set was historical prices in the invalid form; it could be difficult to profit. All public information was already reflected in prices. He referred to companies’ announcements and annual earnings figures and saw these as the semi-strong form’s requirements.
The strong form included all information sets and incorporated in price trends, and no monopolistic information can require profits. Insider trading was excluded from profit-making, and he also explained how the notion of market efficiency could not be removed while the market equilibrium model still existed. These concepts have not found favor in the eyes of some researchers, but they still stand.
The creation of the index and exchange-traded funds is based on Fama’s work on market efficiency. It has been included in about $4.3 trillion of the $18.1 trillion of the Investment Company’s net assets. This was stated in the 2016 Investment Company Factbook. It shows that his work has been used because it has practical importance.
He continues to influence most current generations of finance researchers as he still plays a vital role in maintaining a thought leadership position at the University of Chicago Booth School of Business. In addition, he is Chairman of the Board of Directors at the Center for Research in Security Prices.
There is no doubt that Eugene Fama and all his achievements have influenced stock markets in many places throughout the years.
Eugene Fama and Kenneth French designed the Fama–French three-factor model to describe stock returns in asset pricing and portfolio management.
However, Fama has been controversial recently because of a series of papers that he wrote with co-author Kenneth French; it has caused doubt to be cast on the validity of the (CAPM Pricing Model, which is rooted in the belief that a stock’s beta alone should explain its average return. These papers explained differences in stock returns: value and market capitalization, which they believe are above and beyond a stock market beta, and stock returns differences. They are looked at as anomalies in past work.
Fama–French three-factor model
The Fama-French Three-Factor Model is an extension of the Capital Asset Pricing Model (CAPM) developed by Eugene F. Fama and Kenneth R. French in the early 1990s. This model is designed to describe stock returns through three factors: market risk, the outperformance of small-cap stocks over large-cap stocks, and the outperformance of value stocks over growth stocks. It provides a more detailed framework for assessing the performance of stocks and portfolios, considering factors that CAPM does not.
1. Market Risk (Market Factor)
- Definition: This factor is the same as the single factor in CAPM, representing the excess return of a broad market portfolio over the risk-free rate. It captures the idea that stocks with higher sensitivity to market movements (measured by beta in CAPM) are expected to yield higher returns to compensate for the higher risk.
- Mathematical Representation: The market factor is represented by , where is the return on the market portfolio and is the risk-free rate.
2. Size Factor (SMB for “Small Minus Big”)
- Definition: This factor captures the excess returns of small-cap stocks over large-cap stocks. Historically, small-cap stocks have been observed to outperform large-cap stocks, which is not explained by market risk alone. The SMB factor is “Small Minus Big,” referring to the performance difference between small and large companies.
- Mathematical Representation: SMB is calculated by taking the difference in returns between a portfolio of small-cap stocks and a portfolio of large-cap stocks. It reflects the additional return investors can expect from investing in companies with smaller market capitalizations.
3. Value Factor (HML for “High Minus Low”)
- Definition: This factor explains the higher returns of value stocks than growth stocks. Value stocks are typically undervalued by the market (high book-to-market ratios), while growth stocks are those expected to grow at an above-average rate in the future (low book-to-market ratios). The HML factor is “High Minus Low,” indicating the difference in returns between value and growth stocks.
- Mathematical Representation: HML is calculated by the difference in returns between a portfolio of value stocks (high book-to-market ratio) and a portfolio of growth stocks (low book-to-market ratio), capturing the premium for investing in value stocks.
Applications in Asset Pricing and Portfolio Management
- Asset Pricing: The model helps estimate the expected returns of stocks based on their exposure to these three risk factors, providing a more nuanced view than CAPM.
- Portfolio Management: It aids in diversification by identifying different risk exposures across assets, allowing managers to construct portfolios that target specific factor exposures to optimize risk-adjusted returns.
The Fama-French Three-Factor Model has significantly influenced the fields of finance and investing, leading to the development of more sophisticated multi-factor models that incorporate additional factors such as momentum, profitability, and investment.
Conclusion
Dr. Eugene Fama, renowned as the Father of Financial Management and the progenitor of modern finance, has made indelible contributions to the field through his pioneering research and theories. As a distinguished professor at the University of Chicago, he has shaped the academic landscape of finance with his insightful teachings and mentorship.
Fama’s role as a founding board member of Dimensional Fund Advisors underscores his practical influence on investment strategies and portfolio management. His receipt of the Nobel Memorial Prize in Economics in 2013 is a testament to the profound impact of his work on understanding market dynamics and asset pricing. Dr. Fama has fundamentally transformed our approach to financial management and investment analysis through his groundbreaking research, including developing the Efficient Market Hypothesis and the Fama-French Three-Factor Model.
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