Lesson 1 of 6 · All lessons in this module
  1. Return-generating models, the market model and betaVideo lesson
  2. The CAPM: assumptions, the SML and its limitsVideo lesson
  3. Estimating beta for the cost of equity
  4. Industry betas: unlevering and relevering
  5. The market risk premium and the country risk premium
  6. APT and the four-factor model for the cost of equity

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Lesson 1 of 6 · 15 min

Return-generating models, the market model and beta

Return-generating models link expected return to risk factors; with the market as the only factor, an asset's sensitivity to the market, its beta, measures its systematic risk.

Video lesson · 7 min. Watch it first, then use the text below to go deeper.

In short

  • A return-generating model estimates expected return from given parameters. The general form is a multi-factor model; factors can be macroeconomic, fundamental or statistical.
  • Fama-French add size and book-to-market to the market factor; Carhart adds momentum.
  • The single-index model: E(Ri)−Rf=βi[E(Rm)−Rf]E(R_i) - R_f = \beta_i[E(R_m) - R_f]. It splits total variance into βi2σm2\beta_i^2\sigma_m^2 (systematic) + σei2\sigma_{e_i}^2 (nonsystematic).
  • The market model Ri=αi+βiRm+eiR_i = \alpha_i + \beta_iR_m + e_i is estimated by regression; it is used to estimate beta and abnormal returns.
  • βi=Cov(Ri,Rm)/σm2=ρi,mσi/σm\beta_i = \text{Cov}(R_i, R_m)/\sigma_m^2 = \rho_{i,m}\sigma_i/\sigma_m. The market's beta is 1, the risk-free asset's is 0, and the average stock's beta is 1.
  • Short estimation windows are more current but noisier; three to five years is more accurate but may be out of date.

Return-generating models

Building the market portfolio from scratch is a huge job: for 1,000 assets you would need 1,000 return estimates, 1,000 standard deviations and 499,500 correlations. A simpler route starts from a known portfolio, such as a broad index, and adds assets one at a time based on their effect on the portfolio. That needs only each asset's systematic risk and an expected return from a return-generating model.

The general form is a multi-factor model: expected excess return equals the sum of factor sensitivities (factor loadings or weights) times expected factor premiums. Every such model includes the market return as one factor.

Factors come in three kinds. Macroeconomic factors are economic variables correlated with returns (growth, interest rates, inflation, employment, confidence). Fundamental factors are company characteristics (earnings and growth, cash flow, research spending, advertising, patents). Statistical factors are found by mining past return data; they may have no economic meaning and can be spurious, so analysts prefer macroeconomic and fundamental models.

Two well-known examples: the Fama-French three-factor model adds relative size and relative book-to-market to the market factor; Carhart's four-factor model adds momentum (relative past returns).

Factor model types
TypeFactorsCaution
MacroeconomicGrowth, interest rates, inflation, productivity, employment, confidenceRelationships estimated from the past
FundamentalEarnings, growth, cash flow, R&D, advertising, patentsRelationships estimated from the past
StatisticalWhatever explains past return variance or covarianceMay lack economic meaning; data mining

The single-index model and splitting variance

The simplest case uses one factor, the market: E(Ri)−Rf=βi[E(Rm)−Rf]E(R_i) - R_f = \beta_i[E(R_m) - R_f]. It fits neatly with the CML, which for a diversified portfolio says excess return equals (σi/σm)(\sigma_i/\sigma_m) times the market's excess return.

With realised returns, the model gets an error term: Ri−Rf=βi(Rm−Rf)+eiR_i - R_f = \beta_i(R_m - R_f) + e_i. The error captures non-market surprises and is uncorrelated with the market, so the covariance term vanishes and total variance splits cleanly: σi2=βi2σm2+σei2\sigma_i^2 = \beta_i^2\sigma_m^2 + \sigma_{e_i}^2.

For a well-diversified portfolio, σei2\sigma_{e_i}^2 is zero, so total risk is just βiσm\beta_i\sigma_m. Substituting this into the CML gives exactly the single-index model: the CML and the single-index model agree for diversified portfolios.

00.020.040.060.08Variance0.04670.02620.0729Solvik Energy0.03240.0324MarketSystematic β²σm²Nonsystematic σe²
Solvik's total variance of 0.0729 splits into 0.0467 systematic (1.22×0.03241.2^2 \times 0.0324) and 0.0262 nonsystematic. The market portfolio is all systematic risk: nothing is left to diversify.

The market model and abnormal returns

The market model is the most common single-index implementation: Ri=αi+βiRm+eiR_i = \alpha_i + \beta_iR_m + e_i. Regress historical returns of the asset on historical market returns; the intercept is αi\alpha_i and the slope is βi\beta_i. To match the single-index model, αi=Rf(1−βi)\alpha_i = R_f(1 - \beta_i).

The fitted line gives the return expected from the market's move on a given day. The difference between the actual return and that expected return is the company-specific or abnormal return, eie_i.

-4%-2%0%2%4%-2%0%2%Market returnKestrel returnIndex +1.5%Actual 2.40%Expected 1.82%
The fitted line (α\alpha = 0.02%, β\beta = 1.2) says a 1.5% market day should lift Kestrel 1.82%. It actually rose 2.40%; the 0.58% gap above the line is the abnormal, company-specific return.

Calculating and interpreting beta

Because the error term is uncorrelated with the market, Cov(Ri,Rm)=βiσm2\text{Cov}(R_i, R_m) = \beta_i\sigma_m^2. So beta is the covariance with the market divided by the market's variance, or equivalently correlation times the ratio of standard deviations. It measures how sensitive the asset is to market moves: its systematic risk.

A positive beta means the asset tends to move with the market; a negative beta means it tends to move against it. A beta of zero means no correlation with the market, as for the risk-free asset (zero covariance) or an asset that is volatile but uncorrelated. Total risk alone tells you nothing about beta.

Substituting the market for the asset gives βm=1\beta_m = 1, so the average beta of all assets in the market is 1. Most stocks in developed markets are highly correlated with the market (often above 0.70), so consistently negative betas are rare.

In practice beta is estimated by regressing the asset's returns on market returns (the market model). Short windows such as 12 months reflect current risk better but are less accurate because special events distort them; three to five years is more accurate but may miss recent changes in the business. Any beta estimate may differ from the asset's true current or future systematic risk.

Reading beta
BetaMeaning
> 1Moves more than the market: more systematic risk than average
= 1Moves with the market (the market itself)
0 to 1Moves less than the market
= 0Uncorrelated with the market (e.g. the risk-free asset)
< 0Tends to move against the market
-10%0%10%-10%-5%0%5%10%Market returnAsset returnY (β 1.2)Market (β 1)X (β 0.8)Z (β −0.6)
Expected response to market moves for the third example's securities. Y has the lowest total risk (20%) but the steepest line; Z, the most volatile (45%), tilts the other way. Beta, not σ\sigma, measures systematic risk.

Formulas

General multi-factor model
E(Ri)−Rf=∑j=1kβijE(Fj)=βi1[E(Rm)−Rf]+∑j=2kβijE(Fj)E(R_i) - R_f = \sum_{j=1}^{k}\beta_{ij}E(F_j) = \beta_{i1}[E(R_m) - R_f] + \sum_{j=2}^{k}\beta_{ij}E(F_j)

βij\beta_{ij} = factor loading of asset i on factor j; the market is always one factor.

Single-index model
E(Ri)−Rf=βi[E(Rm)−Rf]E(R_i) - R_f = \beta_i[E(R_m) - R_f]
Variance decomposition
σi2=βi2σm2+σei2\sigma_i^2 = \beta_i^2\sigma_m^2 + \sigma_{e_i}^2

Systematic variance βi2σm2\beta_i^2\sigma_m^2 plus nonsystematic (error) variance.

Market model
Ri=αi+βiRm+eiR_i = \alpha_i + \beta_iR_m + e_i

Estimated by regression; eie_i on a given day is the abnormal return.

Beta
βi=Cov(Ri,Rm)σm2=ρi,mσiσmσm2=ρi,mσiσm\beta_i = \frac{\text{Cov}(R_i, R_m)}{\sigma_m^2} = \frac{\rho_{i,m}\sigma_i\sigma_m}{\sigma_m^2} = \frac{\rho_{i,m}\sigma_i}{\sigma_m}

Worked examples

Example 1 An abnormal return from the market model

A regression of Kestrel Telecom's daily returns on index returns gives α\alpha = 0.0002 and β\beta = 1.2. One day the index rises 1.5% and Kestrel rises 2.4% after winning a large contract. What is Kestrel's abnormal return that day?

Example 2 Beta two ways, and splitting variance

Solvik Energy has a standard deviation of 27% and a correlation of 0.8 with the market, whose standard deviation is 18%. Compute beta from the correlation and from the covariance, then split Solvik's variance into systematic and nonsystematic parts.

Example 3 High volatility, low beta

The market's σ is 15%. Security X: σ 30%, correlation 0.4. Security Y: σ 20%, correlation 0.9. A frontier-market fund Z: σ 45%, correlation −0.2. Which has the highest total risk, and which the highest systematic risk?

On the exam

Expect beta calculations from covariance or correlation, ranking securities by total vs systematic risk, the meaning of the market model's intercept and slope, the market's beta of 1, and the types of factor models.

  • Dividing covariance by σm\sigma_m instead of σm2\sigma_m^2.
  • Inverting the ratio of standard deviations: it is σi/σm\sigma_i/\sigma_m, not σm/σi\sigma_m/\sigma_i.
  • Ranking systematic risk by total σ while ignoring correlation.
  • Assuming a longer estimation window is always better: it is more accurate but may not reflect the asset's current risk.

Check yourself

  1. Q1In the market model Ri=αi+βiRm+eiR_i = \alpha_i + \beta_iR_m + e_i, the slope coefficient is an estimate of the asset's:

  2. Q2A stock has a correlation of 0.5 with the market and a standard deviation of 36%. The market's standard deviation is 15%. The stock's beta is closest to:

  3. Q3The market's σ is 15%. Security X: σ 30%, ρ 0.4. Security Y: σ 20%, ρ 0.9. Security Z: σ 24%, ρ 0.5. Which security has the most systematic risk?

  4. Q4With respect to capital market theory, the average beta of all assets in the market is:

  5. Q5Analysts generally prefer macroeconomic and fundamental factor models to statistical factor models mainly because statistical factors:

  6. Q6Compared with a beta estimated from five years of data, a beta estimated from the last 12 months is most likely:

0/6Check yourself

Answer the 6 questions: +10 XP for each one you get right first time.

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