37CHAPTER
3
Factor Models
Introduction
Factormodels are models that are used to explain the risk/return character-
istics of assets. It is actually a rather loose term that serves to describe a wide
variety of models. However, all the models share the common characteristic
that they may be viewed as extensions to the CAPM model. The premise of
the CAPM model is that the returns of assets are explicable almost com-
pletely by the behavior of the overall market. Each asset is sensitive to the
market in its own characteristic way, and this sensitivity is termed beta.