Capital Asset Pricing Model

A formula for calculating the expected return of a security based on its systematic risk. This return is also called the “cost of equity capital”.

ri = rf + Bi(rm-rf)

Expected Return = Risk Free Return + Beta × Market Risk Premium

Risk Free Return: E.g. 3-month treasury bond is 1.25%

Security Beta: Volatility of returns relative to the entire market. Measure for security risk.

Market Risk Premium: Expected Market Return − Risk Free Return

Higher Systematic Risk(Bi↑) → Higher Expected Return(ri↑)

Fama French Three Factor Model

Add two factors (alpha > 0) to CAPM model. These two factors are cap size and stocks type.

Cap Size (summarized in Beta of “Small Minus Big”): Stocks with smaller market capitalization tend to outperform the stocks with larger market capitalization.

Stocks Type (summarized in Beta of “High Minus Low”): value stocks (companies with higher book-to-market ratio) outperform growth stocks (companies with lower BTM).

ri = rf + Bi(rm-rf) + B_SMB + B_HML

B_SMB: long on portfolio with small cap stocks, short on portfolio with large cap stocks

B_HML: long on portfolio with high BTM stocks, short on portfolio with low BTM stocks

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I am a Machine Learning Engineer with special interest in mental health and finance.

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