SMB stands for "Small [market capitalization] Minus Big" and HML for "High [book-to-market ratio] Minus Low"; they measure the historic excess returns of small caps over big caps and of value stocks over growth stocks.

Second Examination Period — R-Code 1 Introduction to Risk and Return For a long time there has been the search for the true model that explains the cross section of asset returns[1]. It is common knowledge in Finance that the exposure to risk and the return of an investment are connected.

The relationship between risk and return appears to be straight-forward: Since investors like higher expected return but they dislike risk, investors face a trade-off between the risk they take and the expected return they earn[3]. Considering that there are various definitions of risk, that kind of risk has to be defined that is entitled to a risk premium.

Thus, this kind of risk is essential to construct models to explain returns.

Risk is often just regarded as the possibility of a negative development that leads to a loss[4]. In the context of investment decisions, it was more useful to see it as a deviation from Fama french model.

Within Markowitz's Portfolio selection the risk of deviating from expectation was defined as the standard deviation[6]. Initially, this led to the set-up of efficient portfolios and the choice between a risk-free asset and risky assets in which the investor could invest[7].

The aim of efficient portfolio is the diversification effect, which is based on a correlation between the assets of less than one[8]. Constructing portfolios based on the optimal diversification leads to the efficient frontier, which is predicated on the mean-variance dominance criterion.

Dec 25, · Hi, I was readig thru these statements of FF model. These two are factors in FF which determine the required return. SMB (small minus big), a size (market capitalization) factor. SMB is the average return on three small-cap portfolios minus the average return on three large-cap portfolios. Thus SMB represents a small-cap return premium. The value of intercept is which shows that Fama and French model predicts % risk premium above the actual risk premium. However, this value is insignificant as the P-value is which is above The value of intercept, being insignificant, suggests that Fama and French model is valid. Fama and French concluded that since HML seems to be a redundant factor in the sense that its high-average return is fully captured by its exposure to other factors, the four-factor model may well.

Thus, creating an efficient portfolio means that all other possible portfolios with the same risk variance have a lower expected return or that with the same expected return, all other portfolios have a higher risk[9]. Even though the Markowitz model for portfolio selection and diversification appears to be useful, it is only rarely applied.

It is predicated on the fact that investors utility is solely based on the expected risk and return of assets[10]. Diversification aims at reducing and ideally vanishing idiosyncratic risk, which is the risk that is peculiar to a stock[11].

But in modern asset management an asset has to be seen and evaluated in portfolio context[12]. In a diversified portfolio, the idiosyncratic risk can in general be neglected[13].

On account of this, the investor is not entitled to a risk premium for bearing idiosyncratic risk[14].

But the total risk consists of two forms of risk, the already discussed idiosyncratic risk specific risk and the systematic risk market risk [15]. Abbildung in dieser Leseprobe nicht enthalten Figure 1: Decomposition of Total Risk[16] Market risk is associated with market-wide variations, hence it reflects macro events[17].

For instance, changes in the interest rate, government spending, oil prices, foreign exchange rates and other macroeconomic events will affect almost all companies in the market[18].

Consequently, this risk can't be diversified away and is therefore the only kind of risk that is in portfolio context entitled to a risk premium[19]. Since the vulnerability of a company towards those factors is not diversifiable, it implies that an asset earns a systematic risk premium for each risk-factor beta-factor it is exposed to[20].

Solely these factors should be essential to explain and forecast portfolio returns. The literature contains research of a variety of possible risk factors, e. The Fama-French Model and the modifications of it are representatives of the Arbitrage Pricing Theory, which includes not only one but several systematic risk factors to explain excess returns[25].

It states that the only relevant risk for assets is the systematic risk, since investors can diversify idiosyncratic risk[27].

On account of this, the expected return of an asset in the CAPM is based on its systematic risk and the risk-free rate[28]. In particular, systematic risk in the CAPM is measured by one factor, the sensitivity of an asset to the market[29]. This approach is premised on the basic thought that some stocks are more affected by fluctuations of the market than other stocks and thus have a higher systematic risk[30].

Hence, risk depends on the exposure of assets to macroeconomic events[31].

This sensitivity to macroeconomic events of an asset or stock is measured in comparison to the market and defined as beta[32]. In technical terms, this means that beta is the covariance of the stock and the market, divided by the variance of the market[33].

A beta of zero means that an asset or portfolio has no sensitivity to the market and no market risk[34]. On the other hand, a beta of one states that the asset is moving exactly with the market[35].

Accordingly, an asset with a beta greater one is expected to react overproportionally to the market aggressive stock and with a beta of less than one underproportionally[36]. Since a higher beta represents higher systematic risk, it leads to a higher return in comparison to an asset or portfolio with lower beta[37].

Again, the relationship between the risk of an investment and its return is a positive relationship. In the CAPM this relationship exists between the systematic risk beta and the return[38].Dec 06, · This feature is not available right now.

Please try again later. The modified Fama-French Model with an AR(2) process leads to significant results for the twice lagged return in the model in four out of six tested portfolios. Therefore, the in-sample regression reveals a higher model-fit of the modified Fama-French model with AR(2) in Author: Christoph Lohrmann.

It's a pretty terrible model you got.

R^2 never goes down when you add variables. You want it to go up - just add more random variables. Adjusted R^2 adjusts for the degrees of freedom, in your case, telling you that you have variables that need.

The original Fama-French model augmented with a momentum factor has become a common four-factor model used to evaluate abnormal performance of a stock portfolio.

Momentum may be related to liquidity. Liquidity and Efficient Market Anomalies. In portfolio management the Carhart four-factor model is an extension of the Fama–French three-factor model including a momentum factor for asset pricing of stocks.

It is also known in the industry as the MOM factor (monthly momentum). factor model by appending the three Fama-French factors with a momentum factor after the study by Jegadeesh and Titman () on returns to momentum strategies.

The Fama-French and Carhart models appear to be substantially better than the.

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Five Concerns With The Five-Factor Model