9. Risk Factors

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From the course by Indian School of Business

Trading Basics

305 ratings

Indian School of Business

Trading Basics

305 ratings

Course 1 of 5 in the Specialization Trading Strategies in Emerging Markets

The purpose of this course is to equip you with the knowledge required to comprehend the financial statements of a company and understand the various transactions that take place in the stock market so that you can replicate the strategies discovered by the extant academic literature. The first part of the course provides a brief introduction to financial statements and various common filings of firms. You will learn how to obtain information regarding a company's performance from them and use the information to build trading strategies. Next, you are taught basic asset pricing theories so that you will be able to calculate the expected returns of a stock or a portfolio. Finally, you will be introduced to the actual functioning of asset markets, type of players in the market, different types of orders and the efficient ways and opportune time to execute them, trading costs and ways of minimizing them, the concept of liquidity .etc. This knowledge is required to develop efficient algorithm to execute various trading strategies.

From the lesson

Asset pricing theories

Before you start trading, you should first be able to calculate the expected return from a stock. The expected return comes from various asset pricing models such as Capital Asset Pricing Model (CAPM), Arbitrage Pricing Theory (APT) and Fama-French Three Factor Model. The purpose of this module is to equip you with the skills required to calculate the expected returns of a stock (or) a portfolio. After completing this module you will be able to calculate the expected returns of a stock.

1. Expected returns and risk6:27

2. Diversification5:58

4. CAPM Beta6:10

5. Multifactor Models5:55

7. Arbitrage6:32

8. Arbitrage-Free Price6:03

9. Risk Factors4:44

Meet the Instructors

Ramabhadran Thirumalai
Assistant Professor
Indian School of Business

Learning outcomes.

After watching this video you will be able to

describe commonly used risk factors briefly explain why they work.

Commonly used risk factors.

We have discussed multi-factor models and the APT.

But what should these risk factors be?

A number of researchers have proposed various risk factors, but the most popular

of these are those put forth by Eugene Fama and Ken French in 1993.

They proposed three risk factors which they call RMRF, SMB and HML.

RMRF is the return on a market index minus the risk-free rate.

SMB is Small Minus Big which is the return on a portfolio of small companies that is,

companies with low market capitalization, minus the return on a portfolio

of big companies, that is, companies with high market capitalization.

HML is High Minus Low.

Which is the return on a portfolio of high book to market ratio firms,

minus a portfolio of low book to market ratio companies.

RMRF essentially captures the systematic risk of the market index.

The systematic risk originates from macroeconomic factors.

Fama and French argued that small firms are likely

to be more sensitive to sudden changes in business conditions than big firms.

And hence SMB is a factor.

Firms with high values of book-to-market ratios are more likely to be in financial

distress than those with low values and hence HML is a factor.

To understand the HML factor better,

let's first define what book-to-market ratio means.

It is the ratio of a stocks book value to its market value.

The book value comes from the firm's financial statements.

The market value of equity is simply its current market capitalization.

The ratio tells us what its book value is relative towards market value.

While there are many ways of interpreting this ratio,

we will look at one way of interpreting it in the context of the HML factor.

If the ratio is low then it reflects the growth opportunities of the company.

These growth opportunities are captured by a relatively higher market capitalization

leading to a low value for the ratio.

On the other hand, if the ratio is high,

it reflects the company's bad financial health.

Since the company isn't doing well,

it's market value is low relative to its book value leading to a high ratio.

One thing to note is that SMB and HML do not seem obvious choices for risk factors.

But Fama and

French provide empirical justifications to use them as risk factors.

Thus, SMB and HML may capture sensitivity to unknown risk factors

in the macro economy which is why they work well in explaining observed returns.

A large body of research shows that the Fama French Three Factor Model

works in markets all over the world, as well as over time.

But the thing to note is that the model has worked well for

the last 90 years or so.

But there is no guarantee that it will work well for the next 50 or

even 100 years.

This is the problem with having empirical

models rather than theoretical models like the Cap M or APT.

In 1997, Mark Carhart added a fourth factor.

One based on persistence in stock performance

called the Momentum factor, MOM.

This is the return on a portfolio of companies that have performed well in

the recent past, called winners minus a return on a portfolio

of companies that have performed badly in the recent past called losers.

Recent winners continue to perform well

whereas recent losers continue to perform badly.

Historically, these four factors MRMF, SMB, HML and

MOM explain over 80% of the variation in stock returns and

hence they're commonly used risked factors in multi-factor models.

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