• , where R is the actual total return, the expected part of the return, and U stands for the unexpected part of the return. 8
Factor models: announcements, surprises, and expected returns • Any announcement can be broken into two parts: the anticipated or expected part and the surprise or innovation. – Announcement = expected part + surprise • The expected part of any announcement is part of the information the market uses to form the expected return. • The surprise is the news that influences U. 9
Systematic risk and unsystematic risk: a revisit • A systematic risk is any risk that affects a large number of assets (market risk). An unsystematic risk is a risk that specifically affects a single asset or a small group of assets (idiosyncratic risk). – Uncertainty about general economic conditions, such as GNP, interest rates, or inflation, is an example of systematic risk. – In contrast, the unexpected retirement of the company’s president is an unsystematic risk. It is unlikely to have an effect on the whole market. 10
Systematic risk and unsystematic risk • We can break the total risk into two components: – , where m is the systematic risk, which influences all assets in the market to some extent. ε is the unsystematic risk – , because ε A is specific risk of company A, and is unrelated to the specific risk of company B, ε B . 11
Factor models • The influence of a systematic risk (like inflation) on a stock is captured by the beta coefficient. The beta coefficient, β, tells us the response of the stock’s return to a systematic risk. – For example, if a company’s stock is positively related to the risk of inflation, the stock has a positive inflation beta. If it is negatively related to inflation, its inflation beta is negative, and if it is uncorrelated with inflation, its inflation beta is zero. • Suppose we have identified three systematic risks on which we want to focus: inflation, GNP, and interest rate. Thus, every stock will have a beta associated with each of these systematic risks: an inflation beta, a GNP beta, and an interest rate beta. – F stands for a surprise, where it can be inflation, GNP, or interest rates. • This model is called a factor model (3-factor model). A factor is a variable that affects the returns of risky assets in a systematic fashion. 12
Factor models • In general, a K-factor model • In practice, researchers frequently use a one factor model for returns and the factor is the returns on market index. This model is called a market model. It can be written as 13 F R R R R R M M ) (
The single-index model • This model relates returns on each security to the returns on a broad market index of common stock returns. 12/4/18 14
The single-index model • In this model, the covariance depends only on market risk. Therefore, the covariance between any two securities can be written as • The total risk of a security, as measured by its variance, consists of two components: market risk and unique risk.
You've reached the end of your free preview.
Want to read all 43 pages?