Work out an asset's expected return from its sensitivities to each factor and the risk premium on each factor
The idea
Expected return in a multifactor model equals the risk-free rate plus, for each factor, the asset's sensitivity times the factor risk premium. With a sensitivity of 1.2 to a market factor with a 5% premium, −0.3 to a size factor with a 2% premium, and a risk-free rate of 3%, expected return is 3% + 6% − 0.6% = 8.4%. Each factor risk premium is the expected return on a portfolio with a sensitivity of one to that factor and zero to all others, minus the risk-free rate. The trap is multiplying sensitivities by factor portfolios' total returns instead of premiums, or dropping the minus sign on a negative sensitivity.
In the app: 3 practice questions on this outcome, a narrated walkthrough with diagrams, spaced review that brings it back before you forget it.
Take the free diagnostic →More in Using Multifactor Models
- Explain arbitrage pricing theory (APT), the assumptions it rests on, and how it connects to multifactor models
- Say what an arbitrage opportunity is and judge whether one is present
- Explain and contrast the three kinds of factor model: macroeconomic, fundamental, and statistical
- Set out how multifactor models are applied and explain what the results of such analyses show
- Explain what investors can gain by modelling asset returns across several dimensions of risk rather than one
- Explain where active risk comes from, and interpret the information ratio and tracking risk