Investment Management

Fama and French Three Factor Model

Capital Asset Pricing Model (CAPM) is the backbone of modern portfolio theory. According to CAPM, the expected return on stock is a function of its relationship with the market portfolio defined by its beta. However, Eugene Fama and Kenneth French (1992) brought together two more factors and found that stock return is based on a combination of not just market beta but also firm size and value. They came up with a new model known as  Three Factor Model  as an alternative to CAPM.

What is Fama and French Three Factor Model?

Fama and French three factor model expands on the Capital Asset Pricing Model (CAPM) by adding size and value factors in addition to the market risk factor in CAPM.… Read the rest

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Arbitrage Pricing Theory (APT)

A substitute and concurrent theory to the Capital Asset Pricing Model  (CAPM)  is one that incorporates multiple factors in explaining the movement of asset prices. The arbitrage pricing model (APT) on the other hand approaches pricing from a different aspect.    It is rarely successful to analyse portfolio risks by assessing the weighted sum of its components.   Equity portfolios are far more diverse and enormously large for separate component assessment, and the correlation existing between the elements would make a calculation as such untrue.   Rather, the portfolio’s risk should be viewed as a single product’s innate risk.   The APT represents portfolio risk by a factor model that is linear, where returns are a sum of risk factor returns.  … Read the rest

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Diversification of Risk in Portfolio Management

Average investors are risk averse. Therefore, they will be ready to invest into securities under the presumption of an adequate compensation for risk taking. The compensation for the risk taken should be in the form of minimal rate of return for the invested financial assets, and the rate is named the required rate of return. It has two components:

  • Delayed consumption compensation (investors could have purchased goods and services with the assets they are to invest) and
  • Risk acceptance compensation.

Diversification is used to stabilize the potential return, and thus increase the value of the investment. Diversification stands for he investment of capital into several different securities or projects, all together called the portfolio.… Read the rest

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Different Types of Stock Beta

Beta coefficient is a comparative measure of how the stock performs relative to the market as a whole.  It is determined by plotting the stock’s and market’s returns at discrete intervals over a period of time and fitting (regressing) a line through the resulting data points. The slope of that line is the levered equity beta. When the slope of the line is 1.00, the returns of the stock are no more or less volatile than returns on the market. When the slope exceeds 1.00, the stock’s returns are more volatile than the market’s returns.  The beta coefficient is a key component for the  Capital Asset Pricing Model  (CAPM), which describes the relationship between risk and expected return  and  that is used in the pricing of risky securities.… Read the rest

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The Role of Portfolio Management in an Efficient Market

You have learned that a basic principle in portfolio management is the  diversification of securities. Even if all stocks are priced fairly, each still poses firm-specific risk that can be eliminated through diversification. Therefore, rational security selection, even in an efficient market, calls for the selection of a well-diversified portfolio, providing the systematic risk level that the investor wants. Even in an efficient market investors must choose the risk-return profiles they deem appropriate.

The efficient market hypothesis (EMH) states that a market is efficient if security prices immediately and fully reflect all available relevant information.   If the market fully reflects information, the knowledge of that information would not allow an investor to profit from the information because stock prices already incorporate the information.  … Read the rest

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Modern Portfolio Theory – Markowitz Portfolio Selection Model

Markowitz Portfolio Theory

Harry Markowitz developed a theory, also known as Modern Portfolio Theory (MPT) according to which we can balance our investment by combining different securities, illustrating how well selected shares portfolio can result in maximum profit with minimum risk. He proved that investors who take a higher risk can also achieve higher profit. The central measure of success or failure is the relative portfolio gain, i.e. gain compared to the selected benchmark.

Modern portfolio theory is based on three assumptions about the behavior of investors who:

  • wish to maximize their utility function and who are risk averse,
  • choose their portfolio based on the mean value and return variance,
  • have a single-period time horizon.
… Read the rest
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