Carhart Four-Factor Model

Definition

The Carhart Four-Factor Model is an asset pricing model that expands upon the Fama-French Three-Factor Model by adding a fourth factor, which is the momentum factor. This model provides a more comprehensive framework for understanding stock returns by including not just market risk, size, and value, but also the tendency of stocks that have performed well in the past to continue performing well in the future. This extension makes it a valuable tool for investors looking to analyze and predict stock performance.

5 Must Know Facts For Your Next Test

1. The Carhart Four-Factor Model builds on the foundation laid by the Fama-French Three-Factor Model, adding momentum as a significant determinant of asset returns.
2. The momentum factor is calculated based on past stock performance, typically over the prior 12 months, highlighting trends in investor behavior and market dynamics.
3. By including four factors instead of three, the Carhart model aims to provide a better fit for observed stock returns and enhance the explanatory power compared to earlier models.
4. The Carhart model has been widely used in academic research and practical applications for portfolio management, especially in analyzing mutual fund performance.
5. Investors often use the Carhart Four-Factor Model to evaluate whether active fund managers are able to generate excess returns after accounting for risk factors.

Review Questions

• How does the Carhart Four-Factor Model improve upon the Fama-French Three-Factor Model in explaining stock returns?
  • The Carhart Four-Factor Model enhances the Fama-French Three-Factor Model by introducing a momentum factor that accounts for the observed trend where stocks with recent high returns continue to perform well. This addition recognizes that market behavior is influenced not only by market risk, size, and value but also by investor psychology and trends. By including momentum, the Carhart model provides a more complete understanding of stock price movements and improves predictive accuracy.
• Discuss the significance of momentum as a factor in the Carhart Four-Factor Model and its implications for investors.
  • Momentum plays a critical role in the Carhart Four-Factor Model, as it reflects the tendency of stocks that have performed well over a certain period to continue their upward trajectory. This phenomenon can lead investors to adopt strategies that capitalize on these trends, potentially resulting in higher returns. However, it also suggests that market inefficiencies exist, which may allow some investors to achieve excess returns through timely buying and selling based on historical performance data.
• Evaluate how incorporating additional factors like momentum into asset pricing models impacts the assessment of active fund manager performance.
  • Incorporating factors like momentum into asset pricing models such as the Carhart Four-Factor Model allows for a more nuanced evaluation of active fund managers' performance. By adjusting for multiple risk factors, including momentum, investors can better assess whether managers are genuinely delivering alpha or merely benefiting from prevailing trends in stock prices. This deeper analysis helps differentiate between skillful management and mere exposure to favorable market conditions, leading to more informed investment decisions.

Related terms

Fama-French Three-Factor Model: An asset pricing model that explains stock returns through three factors: market risk, size effect (small minus big), and value effect (high minus low book-to-market ratio).

Momentum Effect: A phenomenon where securities that have performed well in the past continue to perform well in the future, while those that have underperformed tend to continue their poor performance.

Alpha: A measure of an investment's performance on a risk-adjusted basis, representing the excess return of an investment relative to the return predicted by a benchmark or model.