Thread by @FabiusMercurius

🎚️ What is Risk Premia? 🎚️

Be honest: Are u a GOAT trader?

Or did you just make 40% returns being long tech stocks through COVID? What is a good way to assess one's trading performance anyways?

In this 🧵 let's deep-dive on α, β, & their importance in measuring returns.
👇

1/ Return = Risk free rate (Rf) + Beta (β) + Alpha (α)

🔑 This is the central equation of this thread.

🔑 Learning to accurately attribute your total return between Rf, β, and α is key for traders to accurately assess their performance.

Let's start at the bottom then move up.

1/ Risk Free Rate -- small risk, small reward

Think about a super safe way to make a little return: ur savings account. Deposit cash, get 0.4% APY.

Treasuries investing is the same deal & even safer. Example: 3 month T-bills. Deposit cash w/ the gov, get 0.07% back in 3 mo.

Treasuries are so-called "risk-free" cuz they have the full faith & credit of the U.S. gov backing them -- as such, they set the minimum baseline return rate (aka the "risk free rate" or Rf) against which other asset classes are compared.

Equation for inflation-adjusted Rf:

What happens when yields rise?
- ⏫ Increase in Rf raises the yields of all other riskier securities (eg. stocks, bonds)

Can Rf go negative?
- Yes, see equation above
If inflation > gov bond rate... then Rf < 0
(In practice, it means investors will pay to put $ in safety assets)

2/ Beta -- take market risk, get market reward (maybe)

For most traders, β accounts for the majority of their portfolio's returns.

β has 2 meanings:
1. the (equity) market risk premium
2. the correlation btw a single asset's return & the market return benchmark (usually S&P500)

#1 was probably colloquialized into existence by macro traders
- to be "long beta" means you're net long the market
- to trade beta means to trade on signals that move whole asset classes rather than singular companies (e.g. the Fed, trade wars, COVID-19)

Historical β over time:

#2 is related to #1

At some point in our evolution, 🐵s wanted to distinguish between:
- stocks that moved with the overall equity market ("positive beta") vs. against ("negative beta")
- stocks that moved at higher volatility than the market ("high beta") vs lower ("low beta")

So we came up with beta the correlation coefficient that measures how much a target asset moves with respect to beta the underlying equity risk premium benchmark.

Yea, confusing.

Here is a chart showing you what different values of beta (the coefficient) represent in practice.

3/ Alpha ... Always seeking α

α is edge.

It measures how much a trader/PM returned vs. how much the market returns.

U must distinguish % performance from α vs from β!

B/c traders w/out edge can do well in a high-beta environment, then get crushed when the credit cycle flips!

Here's the formula for calculating alpha under CAPM (the capital asset pricing model):

α = R_i - (R_f + β x (R_m - R_f))

where:

R_i = realized return of a portfolio
R_m = realized return of the market
R_f = risk-free rate of return
β = correlation of investments vs. market

How to generate alpha in a beta-dominant world?

Some examples:

1. Move the market after u trade (Nancy Pelosi, ICO Tiktok marketers)
2. Information edge ( SAC pre-2013)
3. Stat arb
4. Trade an illiquid asset & create buy/sell walls
5. Front-run a predictable index fund

/end