UNDERSTANDING RISK and RETURN, the CAPM, and the Fama-French Three-factor Model

RISK AND RETURN

• General concept: high risk high return
• “One widely accepted measure of risk is volatility”--- Risk of owning an asset comes from surprises-unanticipated events —
• Risk divided by two:

Systematic risk—influence large number of asset also market risk --- ex: uncertainty about general economic condition

Unsystematic risk/unique/asset specific risk – influence most a small number (can reduced without lowering expected return by using concept of diversification)

“Investing can (and should) be fun. It can be educational, informative and rewarding. By taking a disciplined approach and utilizing the diversification, buy-and-hold and dollar-cost-averaging strategies, you may find investing rewarding even in the worst of times” (investopedia)

• Beta as a measured of systematic risk

CAPM

• “risk free assets, definition has no systematic risk (or unsystematic risk), so a risk free has beta of zero”
• CAPM attempts to quantify the relationship the beta of an asset and its corresponding expected return.
• Logic thing:
1. first consider an assets that has no volatility and thus, no risk: thus the its return do not vary with the market; as a result, the asset has a beta equal to zero and an expected return
2. second consider an assets that moves in lock-step with the market, or has beta of one
3. lastly think about an assets that experience greater swing in periodic return than a market.

“(E(Rx) – Rf ) / βx “ = “(E(Rm) – Rf) / βm”

E(Rx) = Rf + βx [ E(Rm) – Rf ]

Essenctially, the CAPM states that an assets is expected to earn the risk-free plus a reward for bearing risk as measured by that asset’s beta

• CAPM model gives us an estimate of what the return should be given
• CAPM as a tools to Evaluate Fund Managers

“The presence or absence of a positive alpha can be used to evaluate a manager’s performance”

• Regression Analysis: A tool to Employing the CAPM
• Critique of the CAPM
• The CAPM’s true predictive power is questionable
• Many researcher believe that other risk factor have significant impact on expected return in market

• Additional factors increases predictive power

It is obvious that there are a myriad of risk factor facing companies today from market risk, bankruptcy risk, currency risk, etc; and given that the CAPM uses a single factor to describe aggregate risk.

“Addition of independent variables to a regression often improves the explanatory power of model”

FAMA AND FRENCH AND THE THREE FACTOR MODEL

• Size and value Factor create Additional Explanatory Power.

“Value” n “Size” to be the most significant factors outside the market risk

• The SMB and HML factors
• SMB –Size- (small minus Big): designed to measure the additional return investors have historically received by investing in stock of companies with relatively small market capitalization
• HML –value- (High minus Low): constructed to measured the “value premium “ provided to investors for investing in companies with high book-to-market values
• Interpretation of the factor

“Used simply because they work”

• SMB: small company logically should be expected to be more sensitive to many risk factors.
• HML: big valued company gives more return.
• Three factor model

E(Rx) = Rf + βx [ E(Rm) – Rf ] + SxSMB + h_XHML

S_x = Mesaures the level of exposure the size risk

H_x= Measures the level of exposure the value risk

• SMB and HML, provide added descriptive Dimension for riskiness
• Categorizing fund with the Three factor model
• Classifying Fund into Style Buckets
• Specifying Risk Factor Exposure inform investor Choice
• Multivariate Regression and evaluating Managers with the Three Factor Model

CONCLUSSION

CAPM basically is a good tool to represent the relationship between the risk and return but this tool just uses the Market Risk to represent the “risk” in calculation.

Fama and French add this tool –CAPM- with additional factor (Size and value), in order to give more explanatory power.