medium · FRM Part 1
An analyst regresses a stock's excess returns against the Fama-French three factors and finds an R^2 of 0.92. A CAPM regression for the same stock shows an R^2 of 0.65.
What is the best interpretation of this difference?
- The CAPM's single factor misses significant systematic risk related to size and value tilts.
- The three-factor model is suffering from multicollinearity, making the R^2 unreliable.
- The stock has a high degree of idiosyncratic risk that both models fail to capture.
- The stock is currently overpriced, as indicated by the lower CAPM R^2.
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