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CHAPTER TEN

This chapter provides an introduction to factor models and return-generating processes, including the market model and multiple-factor models. The estimation methods for factor models are also discussed.

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CHAPTER TEN

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  1. CHAPTER TEN FACTOR MODELS

  2. FACTOR MODELS AND RETURN-GENERATING 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

  3. FACTOR MODELS AND RETURN-GENERATING PROCESSES • FACTOR MODELS • assume returns of two securities are correlated in some way

  4. FACTOR MODELS AND RETURN-GENERATING PROCESSES • FACTOR MODELS • any unexplained aspects of a return are assumed to be • unique • uncorrelated with the unique aspect of other securities

  5. THE MARKET MODEL • THE MARKET MODEL • is a specific example of a factor model • the general form may be written r i = ai, I + b i, I r + e i, I where the factor is the market index (I) r i is the i th return in the market

  6. THE MARKET MODEL • TWO IMPORTANT FEATURES OF THE ONE-FACTOR MODEL • THE TANGENCY PORTFOLIO • DIVERSIFICATION

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

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

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

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

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

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

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

  14. MULTIPLE-FACTOR MODELS • SECTOR-FACTOR MODELS • sectors possible • utilities • transportation • financial

  15. ESTIMATING FACTOR MODELS • THREE METHODS • TIME-SERIES APPROACH • CROSS-SECTIONAL APPROACH • FACTOR-ANALYTIC APPROACH

  16. ESTIMATING FACTOR MODELS • TIME-SERIES APPROACH • BEGINNING ASSUMPTIONS:

  17. ESTIMATING FACTOR MODELS • TIME-SERIES APPROACH • BEGINNING ASSUMPTIONS: • investor knows in advance of the factors that influence a security's returns

  18. 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

  19. ESTIMATING FACTOR MODELS • CROSS-SECTIONAL APPROACH • BEGINNING ASSUMPTION

  20. ESTIMATING FACTOR MODELS • CROSS-SECTIONAL APPROACH • BEGINNING ASSUMPTION • Identify Attributes: estimates of a securities sensitivities to certain factors

  21. ESTIMATING FACTOR MODELS • CROSS-SECTIONAL APPROACH • BEGINNING ASSUMPTION • Identify Attributes: estimates of a securities sensitivities to certain factors • estimate attributes in a particular period of time

  22. ESTIMATING FACTOR MODELS • CROSS-SECTIONAL APPROACH • BEGINNING ASSUMPTION • Identify Attributes: estimates of a securities sensitivities to certain factors • estimate attributes in a particular period of time • repeat over multiple time periods to estimate the factor’s standard deviations and correlations

  23. ESTIMATING FACTOR MODELS • FACTOR-ANALYTIC APPROACH • BEGINNING ASSUMPTIONS: • neither factor values nor securities attributes are know

  24. ESTIMATING FACTOR MODELS • FACTOR-ANALYTIC APPROACH • BEGINNING ASSUMPTIONS

  25. ESTIMATING FACTOR MODELS • FACTOR-ANALYTIC APPROACH • BEGINNING ASSUMPTIONS: • neither factor values nor securities attributes are know • uses factor analysis approach

  26. ESTIMATING FACTOR MODELS • FACTOR-ANALYTIC APPROACH • BEGINNING ASSUMPTIONS: • neither factor values nor securities attributes are know • uses factor analysis approach • take the returns over many time periods from a sample to identify one or more significant factors generating covariances

  27. END OF CHAPTER 10

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