Using CAPM and Fama-French Models to Evaluate Stock Performance

AFIN818 Session 2 2018 Case Study Assignment Report
STUDENT ID:
Report
Using CAPM model to evaluate each stock and ranking their performance by alpha and
information ratio.
CAPM model gives the return of a stock according to its fundamentals by considering its systematic
risk that is how volatile/risky a stock is in comparison to the market (Damodaran, 2012).
CAPM Return of stock = (Risk free rate + Beta of stock * (Market Risk Premium))
CAPM of each stock of the ten stocks is shown in table 1 in appendix.
Jensen alpha gives the excess return the stock is earning above its theoretical return given by the
CAPM. It is a measure of risk adjusted return as it takes into account the systematic risk via CAPM.
The Alpha determines whether the asset return is acceptable considering the risk that is undertaken. A
positive alpha or in general higher the value of alpha, better is the performance of the stock
(HedgeThink. 2014).
As shown in table 2 in appendix, the performance of BA was best in this period according to Jensen
alpha because its alpha of 22.77% was highest. The IBM was the stock with lowest alpha of -17.79%
that is its actual return was way lower than its theoretical return.
Information ratio is calculated by dividing the excess returns of a portfolio over the benchmark with
the standard deviation of the excess return. It is another measure of risk adjusted return as it tells how
much additional return is being generated considering the risk that is taken.
As shown in the figure table 3 in appendix, according to the information ratio the performance of BA
was best due to highest IR of 1.21 and the performance of IBM was worst because of the lowest IR of
-0.57, which tells additional risk was not worth undertaking in IBM.
Comparing the optimal risky portfolio from 2B and the optimal risky portfolio with constraints
from 2C using both CAPM model and Fama-French 3 factors model.
CAPM model only considers the market risk premium but ignores all the other risk factors. It uses
market beta to measure the volatility of the portfolio returns to the market returns (Damodaran, 2012).
CAPM returns for both the portfolio is shown below:
CAPM Return of unconstrained portfolio = 10.35%
CAPM Return of constrained portfolio = 8.75%
This tells that the theoretical return for the unconstrained portfolio of 10.35% is higher than the 8.75%
return of the constrained portfolio because the systematic or market risk of the unconstrained portfolio
(beta = 1.01) is higher than the systematic risk of constrained portfolio (beta = 0.84). This is because
by putting constraints on the portfolio the investment in risky assets is reduced but this lowers the
theoretical return too.
1 | P a g e

AFIN818 Session 2 2018 Case Study Assignment Report
STUDENT ID:
The 3-factor Famma-French model uses three risk premiums to compute the expected return of the
portfolio. These three factors are Market risk premium: the premium on the risk undertaken by
investing in the market, Size premium: the premium on the risk undertaken by investing in low
capitalisation stocks and Value premium: the premium on the risk undertaken by investing in the
Value stocks that is the stocks with high book to market ratio (Morningstar, 2014).
Following tables show the details for Famma-French model for both the portfolios:
MRP (Rm-Rf) 10.40%
SMB -6.48%
HML -14.46%
According to this model
expected return for
unconstrained portfolio is 47%
and expected return for
constrained portfolio is 17%.
This difference is because the
unconstrained portfolio is way
more sensitive to the market
risk and market risk premium is
a positive number. During this
period the small stocks underperformed the large stocks given by the SMB = -6.48%, it helped
unconstrained portfolio as higher negative size beta of -1.76 tells that this portfolio is more large cap
oriented. Similarly the value stocks underperformed in this period given by HML = -14.46% and it
was beneficial for unconstrained portfolio as it was more invested in growth oriented stocks given by
its value beta of -1.25.
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Unconstraine
d Portfolio
Constrained
Portfolio
Beta market 1.45 1.05
Beta size -1.76 -0.76
Beta value -1.25 0.06
Famma-French three factor
model: Return = Risk Free Rate
+ Market beta * Market risk
premium + Size beta * Small
minus Big(size premium) +
Value beta * High minus
Low(Value premium)
47% 17%