CHAPTER ELEVEN

FACTOR MODELS

FACTOR MODELS AND RETURNGENERATING PROCESSES

FACTOR MODELS
DEFINITION: a model of a return-generating
process that relates returns on securities to the
movement of one or more common factors

FACTOR MODELS AND RETURNGENERATING PROCESSES

FACTOR MODELS
assume returns of two securities are correlated
in some way

FACTOR MODELS AND RETURNGENERATING PROCESSES

FACTOR MODELS
any unexplained aspects of a return are
assumed to be
unique
uncorrelated with the unique aspect of other
securities

THE MARKET MODEL

THE MARKET MODEL
is a specific example of a factor model
the general form may be written

r i = i, I i, I ri, I
where

the factor is the market index (I)

r i is the i th return in the market
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THE MARKET MODEL

TWO IMPORTANT FEATURES OF THE
ONE-FACTOR MODEL
THE TANGENCY PORTFOLIO
DIVERSIFICATION

MULTIPLE-FACTOR MODELS
MULTIPLE FACTOR MODELS
use more than one explanatory variable in the
return-generating process

MULTIPLE-FACTOR MODELS
MULTIPLE-FACTOR MODELS
some of these factors may include
THE GROWTH RATE OF GDP

MULTIPLE-FACTOR MODELS
MULTIPLE-FACTOR MODELS
some of these factors may include
THE LEVEL OF INTEREST RATES

MULTIPLE-FACTOR MODELS
MULTIPLE-FACTOR MODELS
some of these factors may include
THE YIELD SPREAD BETWEEN CERTAIN
VARIABLES

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MULTIPLE-FACTOR MODELS
MULTIPLE-FACTOR MODELS
some of these factors may include
THE INFLATION RATE

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MULTIPLE-FACTOR MODELS
MULTIPLE-FACTOR MODELS
some of these factors may include
THE LEVEL OF OIL PRICES

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MULTIPLE-FACTOR MODELS
SECTOR-FACTOR MODELS
Assumption:
prices may move together for the same industry or
economic sector

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MULTIPLE-FACTOR MODELS
SECTOR-FACTOR MODELS
sectors possible
utilities
transportation
financial

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ESTIMATING FACTOR MODELS

THREE METHODS
TIME-SERIES APPROACH
CROSS-SECTIONAL APPROACH
FACTOR-ANALYTIC APPROACH

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ESTIMATING FACTOR MODELS

TIME-SERIES APPROACH
BEGINNING ASSUMPTIONS:

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ESTIMATING FACTOR MODELS

TIME-SERIES APPROACH
BEGINNING ASSUMPTIONS:
investor knows in advance of the factors that
influence a security's returns

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ESTIMATING FACTOR MODELS

TIME-SERIES APPROACH
BEGINNING ASSUMPTIONS:
investor knows in advance of the factors that
influence a security's returns
the information may be gained from an economic
analysis of the firm

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ESTIMATING FACTOR MODELS

CROSS-SECTIONAL APPROACH
BEGINNING ASSUMPTION

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ESTIMATING FACTOR MODELS

CROSS-SECTIONAL APPROACH
BEGINNING ASSUMPTION
Identify Attributes: estimates of a securitys
sensitivities to certain factors

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ESTIMATING FACTOR MODELS

CROSS-SECTIONAL APPROACH
BEGINNING ASSUMPTION
Identify Attributes: estimates of a securitys
sensitivities to certain factors
estimate attributes in a particular period of time

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ESTIMATING FACTOR MODELS

CROSS-SECTIONAL APPROACH
BEGINNING ASSUMPTION
Identify Attributes: estimates of a securitys
sensitivities to certain factors
estimate attributes in a particular period of time
repeat over multiple time periods to estimate the
factors standard deviations and correlations

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ESTIMATING FACTOR MODELS

FACTOR-ANALYTIC APPROACH
BEGINNING ASSUMPTIONS:
neither factor values nor securities attributes are
known

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ESTIMATING FACTOR MODELS

FACTOR-ANALYTIC APPROACH
BEGINNING ASSUMPTIONS

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ESTIMATING FACTOR MODELS

FACTOR-ANALYTIC APPROACH
BEGINNING ASSUMPTIONS:
neither factor values nor securitys attributes are
known
uses factor analysis approach

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ESTIMATING FACTOR MODELS

FACTOR-ANALYTIC APPROACH
BEGINNING ASSUMPTIONS:
neither factor values nor securitys attributes are
known
uses factor analysis approach
take the returns over many time periods from a
sample to identify one or more significant factors
generating covariances

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