Portfolio Risk & Return: Part 2

Capital Market Line (CML)

• Capital Market Line is a special case of the capital allocation line, where the risky portfolio is
the market portfolio*. The combination of market portfolio with risk-free asset gives a linear
combination of two assets along a straight line, similar to CAL.
• For plotting CML, expected portfolio return is taken on the y-axis and portfolio standard
deviation on x-axis.
• Graphically, the market portfolio is the point on the Markowitz efficient frontier where a line
from the risk-free asset is tangent to the Markowitz efficient frontier.
• All points on the interior of the Markowitz efficient frontier are inefficient portfolios in that
they provide the same level of return with a higher level of risk or a lower level of return
with the same amount of risk.
• When plotted together, the point at which the CML is tangent to the Markowitz efficient
frontier is the optimal combination of risky assets.
• The CML’s intercept on the y-axis is the risk-free return (Rf) because that is the return
associated with zero risk. The CML passes through the point represented by the market
return, E(Rm).
• Any point above the CML is not achievable and any point below the CML is dominated by
and inferior to any point on the CML.
*Typically market portfolio is defined as a local or regional stock market index that can be used
as a proxy for the market, for e.g. S&P 500 is commonly used by analysts as a benchmark for
market performance.
Capital Market Line (CML)
• Risk and return characteristics of the portfolio represented by the CML can be computed by using the risk and return
expressions for a two-asset portfolio:
𝐸 𝑅𝑝 = 𝑤1 𝑅𝑓 + 1 − 𝑤1 𝐸 𝑅𝑚

𝜎𝑝 = 𝑤12 𝜎𝑓2 + (1 − 𝑤1 )2 𝜎𝑚
2
+ 2𝑤1 1 − 𝑤1 𝐶𝑜𝑣 𝑅𝑓, 𝑅𝑚
• The proportion invested in the risk-free asset is given by 𝑤1 and the balance is invested in the market portfolio
1 − 𝑤1 .
• The risk of the risk-free asset is given by 𝜎𝑓 , the risk of the market is given by 𝜎𝑚 and the risk of the portfolio is given
by 𝜎𝑝 and the covariance between the risk-free asset and the market portfolio is represented by Cov 𝑅𝑓, 𝑅𝑚 .
• Further, since the standard deviation of risk-free asset is zero and its covariance with all other assets is also zero, the
standard deviation of the portfolio can be simply expressed as:
𝜎𝑝
𝜎𝑝 = 1 − 𝑤1 𝜎𝑚 𝑜𝑟 𝑤1 = 1 −
𝜎𝑚
• By substituting 𝑤1 in the expected return equation, we can express 𝐸 𝑅𝑝 as:
𝐸 𝑅𝑚 − 𝑅𝑓
𝐸(𝑅𝑝) = 𝑅𝑓 + ∗ 𝜎𝑝
𝜎𝑚
Leveraged
Portfolios
Leveraged Portfolios

• The combination of the risk-free asset and the market portfolio, which may be
achieved by joining point RFR and M, are termed as ‘Lending Portfolios’. In
effect, the investor is lending part of his or her wealth at the risk-free rate.
• In case the investor wants to take more risk, he may be able to move to the
right of the market portfolio (point M) by borrowing money and purchasing
more of portfolio M.
• Assuming the investor is able to borrow at risk-free rate of interest, then the
straight line joining RFR and M can be extended further to the right of point
M, this extended section of the line represents the ‘Borrowing Portfolios’.
• As the investor moves further to the right of point M, an increasing amount of
borrowed money is invested in the market and this negative investment in the
risk-free asset is referred to as the ‘leveraged portfolios’.
 Leveraged
Portfolios with
Different
Lending and
Borrowing
Rates
 • Generally the investors can lend money at risk-free rates
but can’t borrow the money at risk-free rate and has to
Leveraged pay a higher rate of interest than the government
because his ability to pay is not as certain as that of the
Portfolios with government.
• With different lending and borrowing rates, the CML will
Different no longer be a single straight line.
• Thus, the line between point Rf and M will have a slope
Lending & of
(𝐸 𝑅𝑚 −𝑅𝑓 )
𝜎𝑚
and the line to the right of M will have a
Borrowing smaller slope of
(𝐸 𝑅𝑚 −𝑅𝑏 )
𝜎𝑚

Rates • Leverage allows less risk-averse investors to increase the

amount of risk they take by borrowing money and
investing more than 100% in the passive portfolio.
 Total
Variance

Risk –
Meaning &
Pricing
 Systematic Risk is risk that cannot be avoided and is inherent
in the overall market. It is non-diversifiable because it
includes risk factors that are innate within the market and
affect the market as a whole.
Examples of factors that constitute systematic risk include
interest rates, inflation, economic cycles, political uncertainty
Systematic and widespread natural disasters.
Risk &
Nonsystematic Unsystematic Risk is risk that is limited to a particular asset or
industry that need not affect assets outside of that asset
Risk class. Investors are capable of avoiding unsystematic risk
through diversification by forming a portfolio of assets that
are not highly correlated with one another.
Examples of unsystematic risk include strike by employees,
failure of a drug trial, operational risk, legal risk, financing risk
etc.
Return-Generating Models
• A return-generating model is a model that can provide an estimate of the expected return of a security
given certain parameters.
• If systematic risk is the only relevant parameter for return, then the return-generating model will
estimate the expected return for any asset given the level of systematic risk.
• As it is difficult to decide which factors are appropriate for generating returns, the most general form of
a return-generating model is a multi-factor model.
• A multi-factor model allows more than one variable to be considered in estimating returns and can be
built using different kinds of factors such as, macroeconomic, fundamental and statistical factors.
• Macroeconomic factor models use economic factors such as economic growth, interest rate, inflation
rate, productivity and consumer confidence that might have correlation with security returns.
• Fundamental factor model analyses relationship between security return and company’s underlying
fundamentals such as, for example, earnings, earnings growth, cash flow generation, investment in
research, advertising etc.
• Statistical Factor Model considers historical and cross-sectional return data to explain the variance and
co-variance between observed returns.
Return-generating Model Equation
• A general return-generating model is expressed as:
• 𝐸 𝑅𝑖 − 𝑅𝑓 = σ𝑘𝑗=1 𝛽𝑖𝑗 𝐸 𝐹𝑗 = 𝛽𝑖1 𝐸 𝑅𝑚 − 𝑅𝑓 + σ𝑘𝑗=2 𝛽𝑖𝑗 𝐸 𝐹𝑗
• The model has ‘k’ factors,𝐸 𝐹1 , 𝐸 𝐹2 , … … 𝐸 𝐹𝑘
• The coefficients, 𝛽𝑖𝑗 are called factor weights or factor loadings
associated with each factor.
• The left-hand side of the model has excess return, or return over the
risk-free rate and right-hand side provides the risk factors that would
generate the return.
Return-Generating Model: The Single-Index
Model
• The simplest form of a return-generating model is a single-factor linear model, in
which only one factor is considered.
• The most common implementation is a single-index model, which uses the
market factor in the following form:
𝐸 𝑅𝑖 − 𝑅𝑓 = 𝛽𝑖 𝐸 𝑅𝑚 − 𝑅𝑓
• Although the single-index model is simple, it fits nicely with the capital market
line.
• CML is linear with intercept of Rf and a slope of [E(Rm)-Rf]/σm.
• We can rewrite the CML by moving the intercept to the left-hand side of the
equation, rearranging the terms and generalizing the subscript from ‘p’ to ‘i’:
𝜎𝑖
• 𝐸 𝑅𝑖 − 𝑅𝑓 = 𝐸 𝑅𝑚 − 𝑅𝑓
𝜎𝑚
• Thus, The CML reduces to a single-index model.
Decomposition
of Total Risk for
a Single-Index
Model
Decomposition
of Total Risk for
a Single-Index
Model
Return-Generating Models: the Market Model
• The most common implementation of a single-index model is the market
model, in which the market return is the single factor or single index.
• The market model is:
• 𝑅𝑖 = 𝛼𝑖 + 𝛽𝑖 𝑅𝑚 + 𝜀𝑖
• The intercept, 𝛼𝑖 and slope coefficient 𝛽𝑖 are estimated using historical
security and market returns.
• These parameters are then used to predict company specific returns that a
security may earn in a future period.
• Assume that a regression of Wal Mart’s historical daily returns on S&P 500
daily returns give an 𝛼𝑖 of 0.001 and a 𝛽𝑖 of 0.9.Thus, Wal Mart’s expected
daily return = 0.0001+0.90*Rm.
Calculation & Interpretation of Beta
• Beta is a measure of how sensitive an asset’s return is to the market as a whole and is calculated
as the covariance of the security return and market return divided by the variance of the market
return. The expression is equivalent to:
𝐶𝑜𝑣(𝑅𝑖, 𝑅𝑚 ) 𝜌𝑖,𝑚 𝜎𝑖 𝜎𝑚 𝜌𝑖,𝑚 𝜎𝑖
• 𝛽= 2 = 2 =
𝜎𝑚 𝜎𝑚 𝜎𝑚
• Beta captures an asset’s systematic risk, or the portion of an asset’s risk that cannot be eliminated
by diversification.
• Th variances and correlations required for calculation of beta are based on historical returns.
• A positive beta indicates that the return of an asset follows the general market trend, whereas
negative beta shows that the return of an asset generally follows a trend that is opposite to that
of the market.
• A risk-free asset’s beta is zero because its covariance with other assets is zero.
• The market beta can be calculated by substituting 𝜎𝑚 for 𝜎𝑖 and the beta is expressed as:
𝜌𝑖,𝑚 𝜎𝑖 𝜎𝑚 𝜌𝑚,𝑚 𝜎𝑚
• 𝛽= 2 = =1; thus market beta is always 1.
𝜎𝑚 𝜎𝑚
Example: Beta
• Assuming that the risk of the market is 25%, calculate the beta for the
following assets:
1. A short-term US Treasury Bill
2. Gold, which has a standard deviation equal to the standard
deviation of the market but a zero correlation with the market.
3. A new emerging market that is not currently included in the
definition of “market”- the emerging market’s standard deviation is
60% and the correlation with the market is -0.1.
4. An IPO with standard deviation of 40% and a correlation with the
market of 0.7.
Example: Beta
• Solution 1:
A short-term US treasury bill has zero risk. Thus, its beta is 0.
• Solution2:
As the correlation of gold with the market is zero, its beta is zero.
Solution 3:
Beta of the emerging market is: -0.1*0.60/0.25 = -0.24
Solution 4:
Beta of the IPO is 0.7*0.4/0.25 = 1.12
Beta Estimation Using Regression
Beta Estimation Using Regression
• An alternative and more practical approach is to estimate beta
directly by using the market model equation '𝑅𝑖 = 𝛼𝑖 + 𝛽𝑖 𝑅𝑚 + 𝜀𝑖 ′.
• The market model equation can be estimated by using regression
analysis, which is a statistical process that evaluates the relationship
between a given variable and one or more other variables.
• Historical security returns (𝑅𝑖 ) and historical market returns (𝑅𝑚 ) are
inputs used for estimating the two parameters 𝛼𝑖 and 𝛽𝑖 .
• Regression analysis is similar to plotting all combinations of the
asset’s return and the market return (𝑅𝑖 , 𝑅𝑚 ) and then drawing a line
through all points such that it minimizes the sum of squared linear
deviations form the line.
Portfolio Beta
• Consider two securities 1 and 2 with a weight of 𝑤1 and 𝑤2 in security
1 and 2. The return for the two securities and return of the portfolio
can be written as:
𝐸 𝑅1 = 𝑅𝑓 + 𝛽1 𝐸 𝑅𝑚 − 𝑅𝑓
𝐸 𝑅2 = 𝑅𝑓 + 𝛽2 𝐸 𝑅𝑚 − 𝑅𝑓
𝐸 𝑅𝑝 = 𝑤1 𝐸 𝑅1 + 𝑤2 𝐸 𝑅2
= 𝑤1 𝑅𝑓 + 𝑤1 𝛽1 𝐸 𝑅𝑚 − 𝑅𝑓 + 𝑤2 𝑅𝑓 + 𝑤2 𝛽2 𝐸 𝑅𝑚 − 𝑅𝑓
𝑬 𝑹𝒑 = 𝑹𝒇 + 𝒘𝟏 𝜷𝟏 + 𝒘𝟐 𝜷𝟐 𝑬 𝑹𝒎 − 𝑹𝒇
Thus, the portfolio beta is given by 𝒘𝟏 𝜷𝟏 + 𝒘𝟐 𝜷𝟐 , i.e. the weighted
sum of the betas of the component securities.
Example: Portfolio Beta
• Suppose Jane invests 20% of her money in the risk-free
asset, 30% in the market portfolio and 50% in RedHat, a US
stock that has a beta of 2.0. Given that the risk-free rate is
4% and the market return is 16%, what are the portfolio’s
beta and expected return ?
Example: Portfolio Beta
• Solution:
Beta of risk-free asset is 0; beta of market is 1; and beta of RedHat is 2
Portfolio beta = w1β1+w2β2+w3β3
= 20%*0+30%*1+50%*2= 1.30
Portfolio Return= Rf+(w1β1+w2β2)(E(Rm)-Rf)
0.04+ (1.30)(0.16-0.04)=0.196 or 19.6%
Capital Asset Pricing Model (CAPM)
• CAPM provides a linear expected return-beta relationship that
precisely determines the expected return given the beta of an asset.

• CAPM equation is expressed as:

𝐸 𝑅𝑖 = 𝑅𝑓 + 𝛽𝑖 𝐸 𝑅𝑚 − 𝑅𝑓
• CAPM asserts that the expected returns of assets vary only by their
systematic risk as measured by beta.
• Two assets with the same beta will have the same expected return
irrespective of the nature of those assets.
Assumptions of the CAPM
• Investors are risk-averse, utility-maximizing, rational individuals
• Markets are frictionless, including no transaction costs and no taxes.
• Investors plan for the same single holding period.
• Investors have homogeneous expectations or beliefs.
• All investments are infinitely divisible
• Investors are price takers.
Security Market Line
 • The security market line is a graphical
representation of the CAPM with beta,
reflecting systematic risk, on the x-axis and
expected return on the y-axis.
• Using the same concept as capital market line,
Security the SML intersects the y-axis at the risk-free
Market Line rate of return and the slope of this line is the
market risk premium, 𝑅𝑚 − 𝑅𝑓 .
(SML) • In case of Capital Market Line, it is applicable
only to securities or portfolios on the efficient
frontier, while the security market line applies
to any security, efficient or not.
 Security
Selection
using SML
Security Selection Using SML
• Potential investors can plot a security’s expected return and beta
against the SML and use this relationship to decide whether the
security is overvalued or undervalued in the market.
• All securities that reflect the consensus market view are points
directly on the SML(i.e. correctly valued).
• If a point representing the estimated return of an asset is above the
SML (i.e. points A and C), the asset has a low level of risk relative to
the amount of expected return and would be a good choice for
investment. This security is termed as ‘undervalued’.
• If the point representing a particular asset is below the SML(point B),
the stock is considered as ‘overvalued’.
Security Characteristic Line (SCL)
• SCL is a plot of the excess return of the security on the excess return of the
market.
• Jensen’s alpha is the intercept and the beta is the slope. The equation is
expressed as:
• 𝛼𝑖 = 𝑅𝑖 − (𝑅𝑓 + 𝛽 𝑅𝑚 − 𝑅𝑓 .
• The security characteristic line can also be estimated by regressing the
excess security return (𝑅𝑖 - 𝑅𝑓 ) on the excess market return 𝑅𝑚 − 𝑅𝑓 .
• A positive alpha indicates a superior security, whereas a negative alpha
indicates a security that is likely to underperform when adjusted for risk.
Security Characteristic Line (SCL)
Portfolio Performance Evaluation Parameters
1. Sharpe Ratio
2. Treynor Ratio
3. M-squared
4. Jensen’s Alpha
1. Sharpe Ratio
• Sharpe ratio is also known as the reward-to-variability ratio or simply the
slope of the capital allocation line.
• The ratio uses total risk and not systematic risk.
• The portfolio with the highest Sharpe ratio has the best performance, and
the one with the lowest Sharpe ratio has the worst performance.
𝑅𝑝 −𝑅𝑓
• Sharpe ratio is expressed as:
𝜎𝑝
• The Sharpe ratio, however suffers from two limitations:
a) It uses total risk as a measure of risk when only systematic risk is priced
b) The ratio itself is not informative, it becomes useful when it is compared
with another asset Sharpe ratio
2. Treynor Ratio
• Treynor ratio is a simple extension of the Sharpe ratio and resolves the
Sharpe ratio’s first limitation by substituting beta risk for total risk.
𝑅𝑝 −𝑅𝑓
• Treynor ratio is expressed as:
𝛽𝑝
• Treynor ratio does not work for negative beta assets, i.e. the denominator
must be positive for obtaining correct estimates and rankings.
• Although both Sharpe and Treynor ratios allow for ranking of portfolios,
neither ratio gives any information about the economic significance of
differences in performance.
• For instance, among the Treynor ratio of one portfolio is 0.35 and the
Treynor ratio of other portfolio is 0.50. The second portfolio is superior, but
is that difference meaningful? Or is the portfolio better than the passive
market portfolio.
 2
3. M-Squared(𝑀 )
• 𝑀2 was created by Franco Modigliani and his granddaughter, Leah
Modigliani-hence the name M-squared or 𝑀2 .
• 𝑀2 is an extension of the Sharpe ratio and the idea behind the measure is
to create a portfolio (Ṕ) that mimics the risk of a market portfolio – that is,
the mimicking portfolio (Ṕ) alters the weights in portfolio P and the risk-
free asset until portfolio Ṕ has the same total risk as the market (i.e. 𝜎ṕ =
𝜎𝑚 ).
• Because the risks of the mimicking portfolio and the market portfolio are
the same, we can obtain the return on the mimicking portfolio and directly
compare it with the market return.
2 𝜎𝑚
• 𝑀 = (𝑅𝑝 − 𝑅𝑓 ) − (𝑅𝑚 − 𝑅𝑓 )
𝜎𝑝
 2
3. M-Squared(𝑀 )
• 𝑀2 gives us rankings that are identical to those of the Sharpe ratio.
They are easier to interpret and are in percentage terms.
• A portfolio that matches the performance of the market will have an
𝑀2 of zero, whereas a portfolio that outperforms the market will
have an 𝑀2 that is positive.
• By using 𝑀2 , we are not only able to determine the rank of a
portfolio but also which, if any, of our portfolio beta the market on a
risk-adjusted basis.
4. Jensen’s Alpha
• Just like Treynor ratio, Jensen’s alpha is based on systematic risk.
• The difference between the actual return and the risk-adjusted return(as given by CAPM) is a
measure of the portfolio’s performance relative to the market portfolio and is called Jensen’s
alpha.
• Jensen’s alpha is expressed as:
• 𝛼𝑝 = 𝑅𝑝 − 𝑅𝑓 + 𝛽𝑝 𝑅𝑚 − 𝑅𝑓
• By definition, 𝛼𝑚 of the market is zero. Jensen’s alpha is the vertical distance from the SML
measuring the excess return for the same risk as that of the market.
• If 𝛼𝑝 is positive, then the portfolio has outperformed the market; if 𝛼𝑝 is negative, the portfolio
has underperformed the market.
• Jensen’s alpha is commonly used for evaluating institutional managers, pension funds and mutual
funds.
• Values of alpha can be used to rank different managers and the performance of their portfolios,
as well as the magnitude of underperformance or overperformance.
Example: Portfolio Performance Evaluation
• A British pension fund has employed three investment managers, each of whom
is responsible for investing in one-third of all assets classes so that the pension
fund has a well-diversified portfolio. Information about the managers is given
below:
Manager Return σ β
X 10% 20% 1.1
Y 11% 10% 0.7
Z 12% 25% 0.6
Market(M) 9% 19%
Risk-free Rate(Rf) 3%

• Calculate the expected return, Sharpe ratio, Treynor ratio, 𝑀2 and Jensen’s
alpha. Analyze your results and plot the returns and betas of these portfolios.
 Example: Portfolio Performance Evaluation
Manager 𝑹𝒊 𝝈𝒊 𝜷𝒊 E(𝑹𝒊 ) Sharpe Treynor 𝑀2 𝜶𝑰
Ratio Ratio

X 10% 20% 1.10 9.6% 0.35 0.064 0.65% 0.40%

Y 11% 10% 0.70 7.2% 0.80 0.114 9.20% 3.80%

Z 12% 25% 0.60 6.6% 0.36 0.150 0.84% 5.40%

M 9% 19% 1 9% 0.32 0.06 0 0

Rf 3% 0 0 3%
Example: Portfolio Performance Evaluation
Ranking of Portfolios by Performance Measure

Rank Sharpe Ratio Treynor Ratio 𝑴𝟐 𝜶𝑰

1 Y Z Y Z
2 Z Y Z Y
3 X X X X
4 M M M M
5 - - - Rf
Example: Portfolio Performance Evaluation
Constructing a Portfolio
• Once we have constructed SML, any security not included in the
market portfolio can be evaluated to determine whether it should be
integrated in the portfolio or not.
• This decision is based on the alpha of the security (calculated as per
CAPM), so accordingly the security might have a positive alpha and
can be considered for inclusion in the portfolio.
• What should be the relative weight of securities in the portfolio?
𝛼𝑖
• The weight in each nonmarket security should be proportional to 2 ,
𝜎𝑒𝑖
wherein the numerator is the alpha and denominator measures the
non-systematic variance of security i.
Example
• A Japanese investor is holding the Nikkei 225 Index, which is her version of the market. She thinks
that three stocks, P,Q and R which are not in the Nikkei 225, are undervalued and should form a
part of her portfolio. She has the following information about the stocks, the Nikkei225 and the
risk-free rate is given as below (expected return, standard deviation, beta)
P: 15%, 30%,1.5
Q: 18%, 25%, 1.2
R: 16%, 23%, 1.1
Nikkei 225: 12%, 18%, 1.0
Risk-free Rate: 2%,0%,0
1.Calculate the Jensen’s alpha for P,Q and R.
2. Calculate non-systematic variance for P,Q and R (you can use the equation: 𝜎𝑖2 = 𝛽𝑖2 𝜎𝑚 2 2
+ 𝜎𝑒𝑖 )
3. Should any of the three stocks be included in the portfolio? If so, which stock should have the
highest weight in the portfolio
Limitations of CAPM
• True market portfolio is not observable
• Proxy for a market portfolio
• Estimation of beta risk
• Poor predictability of returns
• Homogeneity in investor expectations is not true
Arbitrage Pricing Theory
• Like CAPM, APT proposes a linear relationship between expected return and risk:
• APT is based on three assumptions: (A) a factor model describes asset returns (B)There are
many assets, so investors can form well-diversified portfolios that eliminate asset specific risk
(C ) No arbitrage opportunities exist among well-diversified portfolios.
• According to APT, if the above three assumptions hold, the following equation holds:
𝑬(𝑹𝒑 ) = 𝑹𝒇 + 𝝀𝟏 𝜷𝒑,𝟏 + ⋯ + 𝝀𝒌 𝜷𝒑,𝒌
Where,
𝐸(𝑅𝑝 ) = expected return to portfolio P
𝑅𝑓 = the risk-free rate
λ𝑗 = expected reward for bearing the risk of security ‘j’
𝛽𝑝,𝑗 = the sensitivity of the portfolio to factor ‘j’
K= number of factors
Example: One-Factor APT Model
• Suppose we have three well-diversified portfolios that are each
sensitive to the same single factor. The exhibit presents the expected
returns and factor sensitivities of these portfolios. Assume that the
expected returns reflect a one-year investment horizon.
Portfolio Expected Return Factor Sensitivity
A 0.075 0.5
B 0.150 2.0
C 0.070 0.4

• Calculate the risk-free rate and value of factor risk premium (λ)
Use the single factor APT equation 𝐸 𝑅𝑝 = 𝑅𝑓 + λ1 𝛽𝑝,1 .
Fama & French Three Factor Model
• Kenneth French and Eugene Fama presented a paper, the cross-section of Expected Stock Returns
(1992), were they investigated variables that could explain cross-section expected stock returns
better than the beta value in the CAPM.
• They found two anomalies that the CAPM could not explain, it was the book-to-market equity
ratio (BE/ME) and the size of company (market capitalization).
• They discovered that size has a negative relationship between average returns and firm size and
also that stocks with high BE/ME ratios have higher average returns. (Fama & French 1992).
• They also tested other variables like leverage and earnings/price ratio. But it was the size and
BE/ME factor that showed the most promising results and it was these two variables that they
used to create the three-factor model.
• The three-factor formula is an extended version of the CAPM, the first factor is the same as in the
CAPM which is the beta value for the asset. But in the three-factor model it also exists two others
beta coefficients, this means that the beta is divided in to three beta coefficients. (Fama & French
1992)
Fama & French Three Factor Model
• 𝑹𝒑 − 𝑹𝒇 = 𝒂𝒑 + 𝒃𝒑𝟏 𝑹𝑴𝑹𝑭 + 𝒃𝒑𝟐 𝑺𝑴𝑩 + 𝒃𝒑𝟑 𝑯𝑴𝑳 + 𝒃𝒑𝟒 𝑾𝑴𝑳 + 𝜺𝒑
• Where
𝑅𝑝 and 𝑅𝑓 = the return on the portfolio and the risk-free rate of return
𝑎𝑝 =‘alpha’ or return in excess of that expected given the portfolio ‘s level of systematic risk
𝑏𝑝 = the sensitivity of the portfolio to the given factor
RMRF = the return on a value-weighted equity index in excess of the one-month T-bill rate
SMB = small minus big, a size (market capitalization) factor; SMB is the average return on three small-cap
portfolios minus the average on three large-cap portfolios
HML= high minus low, the average return on two high book-to-market portfolios minus the average
return on two book book-to-market portfolios.
WML = winners minus losers, a momentum factor; WML is the return on a portfolio of the past year’s
losers
𝜀𝑝 = an error term that represents the portion of the return to the portfolio, p, not explained by the
model.
Carhart(1997) Four factor model
• Mark M. Carhart wrote a paper in 1997 where he presented the model as a tool
for valuating mutual funds. The paper based it work of what Fama and French did
with the three-factor model in early 90´s.
• Carhart looked at the previous research and decided to include the momentum
factor in to the three-factor model and he performed the regression analysis on
mutual funds instead of stocks which Fama and French used in their paper.
• The Carhart model can be viewed as a multifactor extension of the CAPM that
explicitly incorporates drivers of differences in expected returns among asset
variables that are viewed as anomalies from a pure CAPM perspective.
• From the perspective of Carhart model, size, value and momentum represent
systematic risk factors; exposure to them is expected to be compensated in the
marketplace in the form of differences in mean return.
Carhart(1997)
Four factor
model