•
, 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.

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- Summer '16
- cheung
- Finance, Capital Asset Pricing Model, Financial Markets, Modern portfolio theory