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Lesson 1 of 6 · 15 min

Return-generating models, the market model and beta

Return-generating models link expected return to risk factors; with the market as the only factor, an asset's sensitivity to the market, its beta, measures its systematic risk.

In short

  • A return-generating model estimates expected return from given parameters. The general form is a multi-factor model; factors can be macroeconomic, fundamental or statistical.
  • Fama-French add size and book-to-market to the market factor; Carhart adds momentum.
  • The single-index model: E(Ri)−Rf=βi[E(Rm)−Rf]E(R_i) - R_f = \beta_i[E(R_m) - R_f]. It splits total variance into βi2σm2\beta_i^2\sigma_m^2 (systematic) + σei2\sigma_{e_i}^2 (nonsystematic).
  • The market model Ri=αi+βiRm+eiR_i = \alpha_i + \beta_iR_m + e_i is estimated by regression; it is used to estimate beta and abnormal returns.
  • βi=Cov(Ri,Rm)/σm2=ρi,mσi/σm\beta_i = \text{Cov}(R_i, R_m)/\sigma_m^2 = \rho_{i,m}\sigma_i/\sigma_m. The market's beta is 1, the risk-free asset's is 0, and the average stock's beta is 1.
  • Short estimation windows are more current but noisier; three to five years is more accurate but may be out of date.

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Return-generating models, the market model and beta · The Capital Asset Pricing Model, Market Model, and Other Factor-Based Equity Models