Page 25 - FINAL CFA SLIDES DECEMBER 2018 DAY 12

Session Unit 12:
42. Portfolio Risk and Return: Part II

LOS 42.d: Explain return generating models (including the market model) and their uses., p.155

Return generating (or multifactor) models are used to estimate the ER on risky securities based on

specific factors (e.g. sensitivity of returns to each specific factor):
• Macroeconomic factors (GDP growth, inflation or consumer confidence)
• Fundamental factors (earnings, earnings growth, firm size, and research expenditures), and
• Statistical factors -these often have no basis in finance theory and are suspect in that they may

represent only relations for a specific time period which have been identified by data mining
tanties
(repeated tests on a single data set)

Expected excess return (above the risk-free rate) for Asset i is the sum of each factor sensitivity or factor
loading (the βs) for Asset i multiplied by the expected value of that factor for the period. The first factor
is often the expected excess return on the market, E(R – R ).
m f
Examples of multifactor models:
• Fama and French -sensitivity of security returns is linked to 3 factors: firm size, firm book value to market

value ratio, and the excess return on the market portfolio above the risk-free rate;
• Carhart suggests a 4th factor that measures price momentum using prior period returns. Together, these 4

factors explains returns differences for U.S. equity securities over the period for which the model has