WEEK 6 : MULTI-FACTOR MODEL

Modern portfolio theory

 In order to build maximize return for a given level of risk.
E(R ) = sum w x E(R ) (w: weight)
p i

 Subject to : SD = sum(n, i=1) sum(n, j=1) w w q q p (w: weight, q:sd, p:corr)

i j i j i,j

 For any given level of risk we can construct an infinite number of portfolios, but only one
will be efficient. It is impossible to generate returns beyond the efficient frontier under
this theory.

Capital asset pricing model

 CAPM builds upon modern portfolio theory.
 Risk-free assets have a return but no risk.
 With CAPM, we can build portfolios that have risk and return characteristics beyonds
efficient frontier.

E(R ) = R + Beta[E(R ) - R ]
i f m f

Where :
E(R )i = Expected return of asset i
Rf = Risk free rate of return
E(R )m = Expected return of the market
[E(R ) - R ]
m f = (equity) market risk premium

Beta = (SD x Corr) / SD market

 SD and p work against each other.

i, i,m

Ex : What is the expected return of an asset when

R : 1.5%
f

Beta : .5
R = 7.5%
m

Ans: E(R ) = 1.5% + .5(7.5% - 1.5%) = 4.5%

i

Jensen’s alpha

 Investment managers against CAPM.

  Investment managers outperform the market by more than would be predicted by Beta.
 This outperformance is known as “Jensen’s alpha”.

R = alpha + R + B(R - R ) ⇔ alpha = R - R - B(R - R )

p f m f p f, m f

Ex :
1. How much Jensen’s alpha did this manager generate when
R = 9.5% ; R = 2.3% ; R - R = 6.25% ; beta = 1.02
p f m f

Ans : alpha = 9.5% - 2.3% - 1.02x6.25%= .83%

2. In the next period, the manager generated 2.85% of Jensen’s alpha. Calculate return.

Ans: R = 2.85% + 2.3% + 1.02x6.25% = 11.53%

p

Fama French 3-factor model

“ Is there any information (reason) in the filters investment managers use?”
 2 groups :
 Value
 SIze
 Reasoned both are “flavors” of risk
 Nothing else matters.
 Exposure to value and size explains (nearly all) performance.
 Stocks with high risk (are shunned) and have low prices and therefore higher expected
returns.
R = alpha + R + B(R - R ) + h.HmL + s.SmB
p f m f

Where :
HmL = high BTM minus low BTM (the value premium)
SmB = Small caps less Big caps (the small cap premium or size premium)
H = exposure to HmL
S = exposure to SmB

***With the FF 3-model…

 B=1… always
 Alpha =< 0
 All that matters is exposure to the value and small caps premia.

Ex :
1. What return do you expect to achieve from a portfolio with an exposure to the value
premium (3.45%) of 37.5%, exposure to the small cap premium (1.83%) 65.4%, a risk
free rate of 2.74% and an equity risk premium of 6.35%?

Ans:
R = 2.74 + 1 x 6.35% + .375 x 3.45 + .654 x 1.83 = 11.58%
p

2. HmL = (4.7%) of -22.99%, SmB = (3.22%) of -25.67%, R = 3.99%, equity risk premium =
f

5.77%, alpha = .12%

Ans:
R = .12 + 3.99 + 5.77 - 25.67 x .0322 - 22.99 x .047 = 7.97%
p
Carhart’s alpha
 Carhart’s alpha uses the four-factor model to analyze manager performance :
 Value
 Size
 Momentum
R = alpha + R + B(R - R ) + h.HmL + s.SmB + u.UmD
p f m f

Where :
UmD = the momentum effect
U = exposure to the momentum effect
Alpha = Carhart’s alpha

Ex :
Find Carhart’s alpha where
R = 9.81% ; R = 4.75% ; equity risk premium = 7.85%
p f

h.HmL = -3.75%.35% ; s.SmB = -2.15%.25% ; u.UmD = 47.58%.0.1%

Ans : Alpha = 9.81% - 4.75% - 7.85% +3.75%.35% +2.15%.25% - 47.58%.0.1% = -.99%