Question

1.Explain the connection between CAPM and the Fama & French model.

2.List and explain different measures of return and risk in finance.

Hint: You could start with the return calculation formula for individual stocks.

Answer 1

1) CAPM stands for capital asset pricing model and Fama French model is an extension of the CAPM model. In the CAPM model beta is a measure of systematic risk and beta is used to calculate the risk premium that should be used for that security. In the Fama & French model it uses three factors to calculate the risk premium for that security, excess market return, size premium and Value premium.

In the CAPM model the risk premium is calculated by

Beta*(Return from market- risk free rate)

In the Fama & French model the risk premium

Beta*(Excess market return-risk free rate) + B (ismb) * SMB + Beta*(ihml) * HML

SMB is the size premium and HML is the value premium

2) To measure the return of a security we can use arithmetic return or geometric return over a period of time. Geometric return takes into the effect of compounding so normally geometric return is lower than the arithmetic return. To measure the risk of a security we use standard deviation of return of security and beta. The standard deviation is a measure of absolute risk, it measures risk in total numbers where beta is a measure of relative risk and it measures risk of a security in terms of relation to the overall market return. There is other measure of risk which are used in combination of standard deviation, beta and arithmetic return. They are like Sharpe ratio and co-efficient of variation. Sharpe ratio is a measure of excess risk over the risk-free rate per unit of standard deviation of portfolio. Coefficient of variation measures risk per unit of return.