# 6

# Asset Pricing Models

In Chapter 5, we looked at a range of risk-adjusted return metrics which were both absolute and relative to a benchmark. As such we were trying to answer the question *which*? In this chapter we will try to answer the question *why*? Asset pricing models allow us to delve deeper into the structure of hedge fund returns in an attempt to explain them as a complex mix of various exposure factors. In doing so, we look beyond the superficial gloss of the beauty contest associated with the array of risk-adjusted return metrics already described. For sophisticated investors, asset pricing models are very useful in the hedge fund selection process since they allow them to figure out if a hedge fund is really producing skill-based returns worth paying for, or whether the hedge fund could easily be replicated at low cost.

## 6.1 THE RISK-ADJUSTED TWO-MOMENT CAPITAL ASSET PRICING MODEL

In Section 5.3.4, we introduced Sharpe's CAPM market model, given by

On rearranging, the alpha term can be written as

Where *α*_{P} is Jensen's alpha. Equation (6.2) can be broken down into two terms

Equation (6.3) has until recently been widely used for the calculation of alpha within the asset ...