Reading 44 : Portfolio Risk and Return (P.2)
4. Explain return generating models (including the market model) and their uses
- Return generating models are used to estimate the expected returns on risky securities based on specific factors. A simplified ⇒ The market model:
Ri = ?i + ?i . Rm + ei
Where: i: Return on asset i, Rm : market return.
?i: intercept, ?i = (1-?i ) x Rf
?i : slope coefficient, ei: abnormal return on asset i.
- Multifactor Models: most commonly used macroeconomic, fundamental, statistic factors.
- Macroeconomic factors: GDP growth, inflation, consumer confidence…
- Fundamental factors: earnings, earnings growth, firm size & research expenditures…
- Statistic factors: have no basis in finance theory & specific time period data set.
⇒ The simplest factor is single-factor model (single-index model)
5. Calculate and interpret beta
Correlation between the returns on asset i with the return on the market index
- This regression line is referred to as the asset’s security characteristic line (SCL)