Modelling - how to identify the sources of hedge funds' returns

In the fourth of a series of articles on hedge fund performance measurement, Edhec looks at how to identify sources of hedge fund returns

The primary financial model is the Capital Asset Pricing Model (CAPM), initiated by Sharpe in 1964. It is a single-factor model in which security prices are governed by their market risks and not their firm-specific risks. Based on a simple statistical regression framework using T historical returns:

Rit = ai + biRmt + eit

where Rit is the return on a given portfolio (or fund) i, ai is the abnormal performance of the portfolio (or fund) i, bi is the sensitivity of the portfolio (or fund) i and Rmt

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