FRM Part I — Formula Sheet with Worked
Examples
Book 1 • Reading 5 (MPT & CAPM) and Reading 6 (APT & Multifactor Models)
Each formula includes every symbol defined and one worked example sum.
READING 5 — Modern Portfolio Theory & CAPM
1. Beta of an asset
βi = Cov(Ri, RM) / σM2 = (ρi,M × σi) / σM
Symbol What it stands for
βi Beta of asset i — sensitivity of the asset's return to market moves (market β = 1)
Ri Return on asset i
RM Return on the market
Cov(Ri, RM) Covariance — how the asset and market move together
2
σM Variance of market returns
ρi,M Correlation between asset i and the market (−1 to +1)
σi Standard deviation of asset i (its total risk)
σM Standard deviation of market returns
Worked example
Given: market σM = 20%, asset σi = 30%, correlation ρ = 0.8.
β = (0.8 × 0.30) / 0.20 = 0.24 / 0.20 = 1.2
Check via covariance: if Cov = 0.048, then β = 0.048 / (0.20)2 = 0.048 / 0.04 = 1.2
2. Capital Market Line (CML)
E(RP) = RF + [ (E(RM) − RF) / σM ] × σP
Symbol What it stands for
E(RP) Expected return of the portfolio
RF Risk-free rate (e.g., T-bill yield)
E(RM) Expected return of the market
σM Market standard deviation (total market risk)
σP Portfolio standard deviation (total portfolio risk)
the bracket The slope of the CML = the market Sharpe ratio
Worked example
Given: RF = 3%, E(RM) = 11%, σM = 20%, portfolio σP = 15%.
E(RP) = 0.03 + [(0.11 − 0.03) / 0.20] × 0.15
= 0.03 + (0.40 × 0.15) = 0.03 + 0.06 = 0.09 = 9%
Note: the CML prices efficient portfolios only (uses total risk σ).
3. CAPM / Security Market Line (SML)
E(Ri) = RF + [E(RM) − RF] × βi
Symbol What it stands for
E(Ri) Expected (required) return on asset i — the hurdle rate
RF Risk-free rate
E(RM) Expected market return
E(RM) − RF Market risk premium (MRP) — extra return for market risk
βi Asset i's beta (systematic risk)
Worked example
Given (Sky-Air): RF = 4%, MRP = 5%, β = 1.5.
E(RSA) = 0.04 + 1.5 × 0.05 = 0.04 + 0.075 = 0.115 = 11.5%
Interpretation: 11.5% is the hurdle rate. Expect > 11.5% → undervalued (buy); < 11.5% → overvalued.
4. Sharpe Performance Index
Sharpe = (RP − RF) / σP
Symbol What it stands for
RP Portfolio return
RF Risk-free rate
RP − RF Excess return (risk premium)
σP Portfolio standard deviation (total risk)
Worked example
Given: RP = 14%, RF = 2.6%, σP = 25%.
Sharpe = (0.14 − 0.026) / 0.25 = 0.114 / 0.25 = 0.456
Uses total risk — works for any portfolio, diversified or not. Higher = better.
5. Treynor Performance Index
Treynor = (RP − RF) / βP
Symbol What it stands for
RP Portfolio return
RF Risk-free rate
βP Portfolio beta (systematic risk only)
Worked example
Given: RP = 14%, RF = 2.6%, βP = 1.1.
Treynor = (0.14 − 0.026) / 1.1 = 0.114 / 1.1 = 0.1036
Uses systematic risk (β) — best for well-diversified portfolios. Higher = better.
6. Jensen's Alpha
αP = E(RP) − { RF + [E(RM) − RF] × βP }
Symbol What it stands for
αP Jensen's alpha — return above the CAPM-required return
E(RP) Portfolio's actual/expected return
RF Risk-free rate
E(RM) Expected market return
βP Portfolio beta
{ ... } The CAPM-required return for the portfolio
Worked example
Given: E(RP) = 14%, RF = 2.6%, E(RM) = 12.5%, βP = 1.1.
CAPM required = 0.026 + (0.125 − 0.026) × 1.1 = 0.026 + 0.1089 = 0.1349
αP = 0.14 − 0.1349 = 0.0051 = 0.51% (positive → outperformance)
7. Tracking Error (TE)
TE = σ(RP − RB)
Symbol What it stands for
TE Tracking error
RP Portfolio return
RB Benchmark return
σ( ... ) Standard deviation of the return difference over time
Worked example
If the period-by-period active returns (RP − RB) have a standard deviation of 9%,
then TE = 9%. (On the exam this is usually just a calculator σ of the differences.)
Some practitioners use the simple difference RP − RB instead.
8. Information Ratio (IR)
IR = [ E(RP) − E(RB) ] / TE
Symbol What it stands for
E(RP) Expected portfolio return
E(RB) Expected benchmark return
numerator Active return
TE Tracking error (active risk)
Worked example
Given: RP = 15%, RB = 12%, TE = 9%.
IR = (0.15 − 0.12) / 0.09 = 0.03 / 0.09 = 0.333
9. Sortino Ratio
Sortino = (RP − RMIN) / downside deviation
Symbol What it stands for
RP Portfolio return
RMIN Minimum acceptable return (set by investor; sometimes = RF)
downside deviation Variability of only the returns falling below RMIN
Worked example
Given: RP = 15%, RMIN = 4%, downside deviation = 7%.
Sortino = (0.15 − 0.04) / 0.07 = 0.11 / 0.07 = 1.571
Like Sharpe, but swaps RF for RMIN and swaps σ for downside deviation.
READING 6 — APT & Multifactor Models
10. General Multifactor Model (returns)
Ri = E(Ri) + β1F1 + β2F2 + ... + βkFk + ei
Symbol What it stands for
Ri Actual return on stock i
E(Ri) Expected return on stock i
βk Factor beta (sensitivity / loading) for factor k
Fk Surprise in factor k = actual value − expected value
ei Firm-specific (idiosyncratic) error term; expected value = 0
Worked example
Given: GDP beta = 2.0. Consensus GDP = 3.2%, actual = 2.2% → surprise = −1.0%.
Factor contribution = 2.0 × (−0.01) = −0.02 = −2%
The GDP miss drags the stock down 2% (double the move, because β = 2.0).
Every F is a SURPRISE (actual − expected), never the raw value.
11. Single-Factor Model
RHCI = E(RHCI) + βGDP*FGDP* + eHCI
Symbol What it stands for
RHCI Actual return on the stock (HealthCare Inc.)
E(RHCI) Expected return on the stock
βGDP* Beta to GDP surprises ( * denotes 'surprise' )
FGDP* GDP surprise = actual GDP − expected GDP
eHCI Firm-specific error term
Worked example
Given: E(R) = 10%, β = 2.0, expected GDP = 3.2%, actual GDP = 2.6% → surprise = −0.6%.
RHCI = 0.10 + 2.0 × (−0.006) = 0.10 − 0.012 = 0.088 = 8.8%
12. Multifactor Model (two factors)
RHCI = E(RHCI) + βGDP*FGDP* + βCS*FCS* + eHCI
Symbol What it stands for
βCS* Beta to consumer-sentiment surprises
FCS* Consumer-sentiment surprise = actual − expected
(others) Same as the single-factor model above
Worked example
Add: CS beta = 1.5, expected CS = 1.0%, actual CS = 0.75% → surprise = −0.25%.
RHCI = 0.10 + 2.0(−0.006) + 1.5(−0.0025)
= 0.10 − 0.012 − 0.00375 = 0.0843 = 8.43%
Closer to the actual 8.25% than the single-factor 8.8% — the extra factor captured more systematic risk.
13. Fama-French Three-Factor Model
E(Ri) = RF + βi,MRPM + βi,SMBFSMB + βi,HMLFHML + ei
Symbol What it stands for
E(Ri) Expected return on stock i
RF Risk-free rate
βi,M Stock's beta to the market
RPM Market risk premium ( E(RM) − RF )
βi,SMB Stock's sensitivity to the size factor
FSMB 'Small minus big' — return of small firms minus big firms
βi,HML Stock's sensitivity to the value factor
FHML 'High minus low' — high book-to-market minus low book-to-market firms
ei Firm-specific return; any deviation from the model = alpha (α)
Worked example
Given: βM = 0.85, βSMB = 1.65, βHML = −0.25;
RPM = 8.5%, FSMB = 2.5%, FHML = 1.75%, RF = 2.75%.
E(Ri) = 0.0275 + 0.85(0.085) + 1.65(0.025) + (−0.25)(0.0175)
= 0.0275 + 0.07225 + 0.04125 − 0.004375 = 0.1366 = 13.66%
Quick memory hooks
• σ = total risk → used in Sharpe, Sortino, CML.
• β = systematic risk only → used in Treynor, Jensen, CAPM.
• In every multifactor formula, each F is a surprise (actual − expected), never the raw value.
• Positive Jensen's α or a portfolio Sharpe/Treynor above the market → outperformance.