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Capital Asset Pricing Model, Part Three – Other Assumptions

Capital Asset Pricing Model, Part Three – Other Assumptions

In Parts One and Two of our examination of the Capital Asset Pricing Model (CAPM), we evaluated two major assumptions:

1)     Market returns are properly modeled by a normal distribution

2)     Beta (systematic risk) is the sole source of priced risk for an asset or portfolio of asset

As you recall, we found several weaknesses in both assumptions as they may apply to hedge funds. This time, we’ll examine the remaining assumptions underlying CAPM, and see if each is reasonable when applied to hedge fund trading.

CAPM assumes: Continue reading “Capital Asset Pricing Model, Part Three – Other Assumptions” »

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Copyright 2011 Eric Bank, Freelance Writer
Risk and Return: Alpha

Risk and Return: Alpha

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In our previous blog, we discussed the concept of beta as it applies to the risk and return of an investment. Recall that beta is the price movement in an individual investment that can be accounted for by the price movement of the general market.  If your investment has a beta of 1.0 and the market returns 10%, your investment should also return 10%.  If your investment returns over 10%, the excess return is called alpha. Alpha is derived from a in the formula Ri = a + bRm which measures the return on a security (Ri) for a given return on the market (Rm) where b is beta.

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Copyright 2010 Eric Bank, Freelance Writer
Beta

Beta

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Hedge funds use an array of strategies to guide trading.  Most of these strategies seek to decouple returns from those of the overall market, as measured by a statistic called “beta” (β). Beta is calculated by dividing the covariance of an investment’s return by the variance of a portfolio or market return:

βi = Cov (ri, rm) / Var(rm) where i = an investment, m = market portfolio, and r = return

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Copyright 2010 Eric Bank, Freelance Writer