Foundations Formulas

FRM 2010 Formulas

By David Harper, CFA FRM CIPM

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Table of Contents
Table of Contents........................................................................................ 1
Define valueatrisk (VaR) and describe how it is used in risk management. ................... 2
Describe how the covariance/correlation of returns between securities affects the returns
distribution of a portfolio of securities. .............................................................. 2
Describe the capital market line (CML) and the construction of the efficient frontier both
with and without a riskfree asset. ................................................................... 3
List the CAPM's underlying assumptions. ............................................................. 4
Calculate, compare, and evaluate the Treynor measure, the Sharpe measure, and Jensen's
alpha. ..................................................................................................... 4
Compute and interpret tracking error, the information ratio, and the Sortino ratio. ......... 5
Define and describe the components of the Arbitrage Pricing Theory (APT) model. .......... 6

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FRM 2010 FOUNDATIONS FORMULAS 1

Define valueatrisk (VaR) and describe how it is used in risk

management.
VaR summarizes the worst loss over a target horizon that will not be exceeded with a given level
of confidence. An equivalent, but arguably superior expression is: VaR is the minimum loss
expected with probability equal to the significance level (1 - confidence).
Here is an example of a VaR statement: Under normal market conditions, the most the portfolio
can lose over a month is about $3.6 million at the 99% confidence level
Notice the user must specify two conditions: target horizon and confidence level. Generically,
then, the VaR statement is: Under normal market conditions, the most the portfolio can lose
over the target horizon is $X or %Y at the selected confidence level.
A VaR metric (or statement) requires two user specifications (choices): horizon and
confidence. For any given asset/portfolio, there are an unlimited number of combinatios;
e.g., 95% 1-day VaR, 99% 1-year VaR
VaR is mathematically given by:

P(L VaR ) 1 c

P( L VaR ) 1 c

Covariance/correlation of Returns between Securities

Describe how the covariance/correlation of returns between securities
affects the returns distribution of a portfolio of securities.
The variance of the two-asset portfolio is given by:

a2b wa2 a2 wb2 b2 2wa wb cov(a, b)

a2b wa2 a2 wb2 b2 2wa wb a b
cov(a, b) a b

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cov(a, b)

a b

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Describe the capital market line (CML) and the construction of the
efficient frontier both with and without a riskfree asset.
The capital market line (CML) is given by:

E( RM ) RF
E( RP ) RF
M

In the SML, there is a linear relationship between the securitys expected excess return (i.e.,
expected return minus the riskless rate) and the markets expected excess return (i.e., the equity
risk premium). The linear relationship is a function of the securitys beta:

E(Ri ) RF i[ E(Rm ) RF ]
Beta
Beta is a measure of an assets sensitivity to movements in the market. In words, a securitys
beta is the covariance of the return of the security with the return of the market portfolio
divided by the variance of the return of the market portfolio:

Cov( Ri , RM )
2
M

Capital asset pricing model (CAPM)

The capital asset pricing model (CAPM) is given by:

E(Ri ) RF i[E(RM ) RF )]
The capital asset pricing model (CAPM) tells us that the expected excess return of a risky
security is equal to the systematic risk of that security measured by its beta times the market's
risk premium. The key insight of the CAPM is that a securitys risk premium is proportional to its
systematic risk.

Diversification and Risk Management

The value of the firms equity is future expected cash flows discounted at a rate determined by
the CAPM:

ValueEquity

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Expected [future cash flows]

1+R F [ E( Rm ) RF ]

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Underlying Assumptions of the CAPM

List the CAPM's underlying assumptions.

Investors are risk averse and seek to maximize the expected utility of their wealth at the
end of the period.

When choosing their portfolios, investors only consider the first two moments of return
distribution: the expected return and the variance.

Investors only consider one investment period and that period is the same for all
investors.

Investors have a limitless capacity to borrow and lend at the risk-free rate (unlimited
lending and borrowing)

Information is accessible cost-free and is available simultaneously to all investors. All

investors therefore have the same forecast return, variance and covariance expectations
for all assets (perfect, costless information).

Markets are perfect: there are no taxes and no transaction costs. All assets are traded and
are infinitely divisible.

Treynor Measure, Sharpe Measure, and Jensens Alpha

Calculate, compare, and evaluate the Treynor measure, the Sharpe
measure, and Jensen's alpha.
The Treynor measure: excess return divided by portfolio beta ():

TP

E( RP ) RF

The Sharpe measure: excess return divided by portfolio volatility (standard deviation):

SP

E( RP ) RF
( RP )

Jensens alpha is the excess return equated to alpha plus expected systematic return:

E(RP ) RF P P (E(RM ) RF )

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Tracking Error (TE), Information Ratio (IR), and Sortino Ratio

Compute and interpret tracking error, the information ratio, and the
Sortino ratio.
Each of these metrics (i.e., tracking error [TE], the information ratio [IR] and the Sortino ratio) is
used to evaluate portfolio performance.

Tracking Error (TE)

Tracking error (TE) is the standard deviation of the difference between the portfolio return and
the benchmark return:

TE (RP RB )
Tracking error is used to analyze benchmark funds; i.e., funds that assume a risk profile (and
construction, generally) similar to a particular profile but then deviates from the benchmark in
an attempt to add value. The ideal, of course, is to add value without assuming additional risk.

Information ratio (IR)

The information ratio (IR, aka, the appraisal ratio) is given by:

IR

E( RP ) E( RB )
( RP RB )

The information ratio (IR) is also used to evaluate the manager of a benchmark fund. It helps to
answer the question, was the manager sufficiently rewarded for the risk incurred by deviating
from the benchmark?

Sortino Ratio
The Sortino ratio is given by:

Sortino ratio =

E(R P ) MAR
T
1

T t 0

RPt MAR

RPt MAR

The Sortino ratio has a similar idea to the Sharpe ratio, but the risk-free rate is replaced with the
minimum acceptable return (MAR).

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Define and describe the components of the Arbitrage Pricing Theory

(APT) model.
According to Grinold:

The APT is a model of expected returns.

Application of the APT is an art, not a science.

The APT points the quantitative manager toward the relationship between factors and
expected returns.

APT factors can be defined in a multitude of ways. These may be fundamental, technical,
or macro factors.

The flexibility of the APT makes it inappropriate as a model for consensus expected
returns, but an appropriate model for a manager's expected returns.

The APT is a source of information to the active manager. It should be flexible. If all active
managers shared the same information, it would be worthless.

The APT maintains that the expected excess return on any stock is determined by that
stock's factor exposures and the factor forecasts associated with those factors.
Excess returns are simply returns in excess of the riskless (riskfree) rate. Get in the habit
of seeing that excess returns are net of the riskfree rate; e.g., CAPM says the expected
excess return is the product of [quantity of risk]*[price of risk].
APT postulates a multiple-factor model of excess returns. APT assumes that there are K factors
such that the excess returns can be expressed as:
K

rn X n,k bk un
k 1

X(n,k) = the exposure of stock (n) to factor (k). These exposures are factor loadings. For practical
purposes, we will assume that the exposures are known before the returns are observed.
b(k) = the factor return for factor k. These factor returns are either attributed to the factors at
the end of the period or observed during the period.
u(n) = stock (n)'s specific return; i.e., the return that cannot be explained by the factors. This is
also called the idiosyncratic return to the stock. The excess return contains an unexplained
specific (idiosyncratic) return
In regard to expected excess return

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f n E {rn } X n,k mk
k 1

m(k) = the factor forecast for factor k.

The factor forecast is simply the sum of [Exposure(k) * Factor(k)].
The first APT above is an ex post regression-type model that expects residuals. The
second APT is an ex ante model of expected returns; in this case, the expected (average)
residual is zero so the (u) drops out.

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