Chapter 7. Multifactor Models and Performance Measures

In Chapter 6, Capital Asset Pricing Model, we discussed the simplest one-factor linear model: CAPM. As mentioned, this one-factor linear model serve as a benchmark for more advanced and complex models. In this chapter, we will focus on the famous Fama-French three-factor model, Fama-French-Carhart four-factor model, and Fama-French five-factor model. After understanding those models, readers should be able to develop their own multifactor linear models, such as by adding Gross Domestic Product (GDP), Consumer Price Index (CPI), a business cycle indicator or other variables as an extra factor(s). In addition, we will discuss performance measures, such as the Sharpe ratio, Treynor ratio, and Jensen's alpha. In particular, the following topics will be covered in this chapter:

• Introduction to the Fama-French three-factor model
• Fama-French-Carhart four-factor model
• Fama-French five-factor model
• Other multiplefactor models
• Sharpe...