SUMMARY
Factor models are models that are used to explain the risk return char-
acteristics of assets and come in many flavors.
Even though the details may vary, factor models are firmly based on the
principles of arbitrage pricing theory (APT).
A factor model is considered fully specified by the factor exposures, the
factor covariance matrix, and the specific variance matrix.
A factor model may be used as a framework to estimate many com-
monplace parameters that may be needed in the course of the investment
process.
Examples of such computations include the estimation of risk on a port-
folio, the evaluation of portfolio beta, and computing the contents of a
tracking basket.
The factor covariance matrix is a crucial piece of information that the
factor model provides. However, it must be used with care.FURTHER READING MATERIAL
King, Benjamin F. “Market and Industry Factors in Stock Price Behavior.” Journal
of Business39, no. 1 (1966): 139–190.
Ross, Stephen A. “The Arbitrage Theory of Capital Asset Pricing.” Journal of Eco-
nomic Theory13 (1976): 341–360.
Jarrow, Robert and Andrew Rudd. “A Comparison of the APT and CAPM: A
Note.”Journal of Banking and Finance7, no. 3 (1983): 295–303.
Grinold, Richard C. and Ronald N. Kahn, Active Portfolio Management, Second
Edition. (New York: McGraw-Hill, 1999).
Factor Models 51