Attilio Meucci

REVIEW of FACTORS MODELS

http://ssrn.com/abstract=1635495

A. MEUCCI Review of factor models

Definition of factor models

Market
Constant

Prices, price changes,

returns, spreads, spread
changes, impl. vol. surf., etc.

Exposures
Risk factors
Residuals

Market

Constant

Exposures of market to factors

Factors

Residuals

A. MEUCCI Review of factor models

Definition of factor models

Market with given distribution
Constant
Exposures
Risk factors
Residuals

estimation

time series

modeling

decision
time (now)

investment
horizon

A. MEUCCI Review of factor models

Definition of factor models

Market
Constant
Exposures
Risk factors
Residuals

Dominant +
residual
factor model

fitness

A. MEUCCI Review of factor models

Definition of factor models

Market
Constant
Exposures
Risk factors
Residuals

Dominant +
residual
factor model

A. MEUCCI Review of factor models

Definition of factor models

Market
Constant
Exposures
Risk factors
Residuals

Dominant +
residual
factor model

A. MEUCCI Review of factor models

Definition of factor models

Market
Constant
Exposures
Risk factors
Residuals

Systematic +
idiosyncratic
factor model
not
correlated

A. MEUCCI Review of factor models

Definition of factor models

Market
Constant
Exposures
Risk factors
Residuals

Systematic +
idiosyncratic
factor model

not
correlated

A. MEUCCI Review of factor models

Definition of factor models

A. MEUCCI Review of factor models

Definition of factor models

not
correlated
not
correlated

A. MEUCCI Review of factor models

Definition of factor models

Market
Constant
Exposures
Risk factors
Residuals

Systematic +
idiosyncratic
factor model

A. MEUCCI Review of factor models

Definition of factor models

Market
Constant
Exposures
Risk factors
Residuals

Dominant +
residual
factor model

Systematic +
idiosyncratic
factor model

All factor models are dominant + residual

No factor model is systematic + idiosyncratic

A. MEUCCI Review of factor models

dominant + residual

idiosyncratic

systematic

A. MEUCCI Review of factor models

Application example

Time series models

Market

stock returns

Constant

betas

Exposures

- S&P index return, industry indices,

Risk factors exogenous

Residuals

A. MEUCCI Review of factor models

Application example

Time series models

Market

stock returns

Constant

betas

Exposures

- S&P index return, industry indices,

Risk factors exogenous

Residuals

Dominant + residual factor model

A. MEUCCI Review of factor models

Application example

Time series models

Market

stock returns

Constant

betas

Exposures

- S&P index return, industry indices,

Risk factors exogenous

Residuals

Dominant + residual factor model

(no constraints)

A. MEUCCI Review of factor models

Time series models

Application example

Market

stock returns

Constant

betas

Exposures

- S&P index return, industry indices,

Risk factors exogenous

Residuals

Dominant + residual factor model

9.
(no constraints)

Systematic + idiosyncratic factor model

A. MEUCCI Review of factor models

Application example

Cross-section models
Market

stock returns

Constant

GICS 1/0 industry partition

Exposures exogenous

industry factors

Risk factors
Residuals

A. MEUCCI Review of factor models

Application example

Cross-section models
Market

stock returns

Constant

GICS 1/0 industry partition

Exposures exogenous

industry factors

Risk factors
Residuals

Dominant + residual factor model

A. MEUCCI Review of factor models

Application example

Cross-section models
Market

stock returns

Constant

GICS 1/0 industry partition

Exposures exogenous

industry factors

Risk factors
Residuals

Dominant + residual factor model

A. MEUCCI Review of factor models

Application example

Cross-section models
Market

stock returns

Constant

GICS 1/0 industry partition

Exposures exogenous

industry factors

Risk factors
Residuals

Dominant + residual factor model

(no constraints)

A. MEUCCI Review of factor models

Cross-section models
Market

Application example

stock returns

Constant

GICS 1/0 industry partition

Exposures exogenous

industry factors

Risk factors

Dominant + residual factor model

9.

Residuals

(no constraints)

Systematic + idiosyncratic factor model

A. MEUCCI Review of factor models

Application example

yield curve changes

Statistical models
Market
Constant

market / slope / butterfly

Exposures not exogenous

parallel shift / tilt / twist

Risk factors not exogenous

Residuals

A. MEUCCI Review of factor models

Application example

yield curve changes

Statistical models
Market
Constant

market / slope / butterfly

Exposures not exogenous

parallel shift / tilt / twist

Risk factors not exogenous

Residuals

Dominant + residual factor model

A. MEUCCI Review of factor models

Application example

yield curve changes

Statistical models
Market
Constant

market / slope / butterfly

Exposures not exogenous

parallel shift / tilt / twist

Risk factors not exogenous

Residuals

Dominant + residual factor model

A. MEUCCI Review of factor models

Application example

yield curve changes

Statistical models
Market
Constant

market / slope / butterfly

Exposures not exogenous

parallel shift / tilt / twist

Risk factors not exogenous

Residuals

Dominant + residual factor model

(no constraints)

A. MEUCCI Review of factor models

Statistical models
Market

Application example

Constant

yield curve changes

market / slope / butterfly

Exposures not exogenous

parallel shift / tilt / twist

Risk factors not exogenous

Dominant + residual factor model

9.

Systematic + idiosyncratic factor model

Residuals
(no constraints)

A. MEUCCI Review of factor models

dominant + residual

idiosyncratic

systematic

A. MEUCCI Review of factor models

Relationships with asset pricing

A. MEUCCI Review of factor models

portfolio return

Relationships with asset pricing

A. MEUCCI Review of factor models

portfolio return

max. Sharpe ratio portfolio

Relationships with asset pricing

A. MEUCCI Review of factor models

Relationships with asset pricing

portfolio return

max. Sharpe ratio portfolio

risk-free return

A. MEUCCI Review of factor models

Relationships with asset pricing

portfolio return

risk-free return

max. Sharpe ratio portfolio

Capital Asset Pricing Theorem (CAPM):

market portfolio
If all investors trade off
expectation and variance and
the distribution is known

A. MEUCCI Review of factor models

Relationships with asset pricing

Capital Asset Pricing Theorem (CAPM):

- Only refers to returns, not generic variables X

- Refers to yet-to-be realized returns, no regression

- Refers to returns of any asset (exotic derivatives, etc.), not only stocks

- Is a constraint on expectations only

- Is not a time series factor model with one explicit factor, the market return

- Has identification issues

- In factor modes the beta is arbitrary

A. MEUCCI Review of factor models

portfolio return

Relationships with asset pricing

A. MEUCCI Review of factor models

Relationships with asset pricing

portfolio return

Arbitrage Pricing Theory (APT):

If R is a systematic +
idiosyncratic model

risk-free return

A. MEUCCI Review of factor models

Relationships with asset pricing

portfolio return

Arbitrage Pricing Theory (APT):

If R is a systematic +
idiosyncratic model

risk-free return

1st factor-mimicking
pseudo portfolio

K-th factor-mimicking
pseudo portfolio

A. MEUCCI Review of factor models

Relationships with asset pricing

Arbitrage Pricing Theory (APT):

- Only refers to returns, not generic variables X

- Refers to yet-to-be realized returns, no regression

- Refers to returns of any asset (exotic derivatives, etc.), not only stocks

- Is a constraint on expectations only

- Is not a time series factor model with K explicit factor, the mimicking portfolios

- Has identification issues