CAIA L2 - 3.3 - Multi-Factor Equity Pricing Models Flashcards
Quote
Major Categories of Factors
(of multifactor asset pricing)
3.3 - Multi-Factor Equity Pricing Models
- Macroeconomic factors affect asset returns across the entire economy. These are systematic risk factors like productivity, inflation, liquidity, and interest rate levels.
- Fundamental, style, investment, or dynamic factors are empirically identified factors that have been fundamentally linked to firm attributes. This category includes style factors like value, momentum, size, low volatility, and quality.
- Statistical factors are empirically identified, but they do not have any known connection with either economic or style factors.
3.3 - Multi-Factor Equity Pricing Models
List
Intercept of the regression (Alpha) indicate superior return if …
3.3 - Multi-Factor Equity Pricing Models
1 - The variables must be tradable assets.
2 - The model must include all potential sources of systematic risk.
3 - The intercept coefficient must be statistically significant.
3.3 - Multi-Factor Equity Pricing Models
Formula
Fama-French Model
Fama-French-Carhart Model
Fama-French five-factor model
3.3 - Multi-Factor Equity Pricing Models
Fama-French Model 3 factors = Market Size Value
E’Ri’ – R’f’ = β’i’[E(R’m’) – R’f’] + β’1i’[E(R’s’ – R’b’)] + β’2i’[E(R’h’ – Rl’)]
Fama French Carhart Model 4 factors = Market Size Value + Momentum
E’Ri’ – R’f’ = β’i’[E(R’m’) – R’f’] + β’1i’[E(R’s’ – R’b’)] + β’2i’[E(R’h’ – Rl’)] + β’3i’[E(R’w’ – R’d’)]
5 factors = Market Size Value Robustness (profitability) & Conservativeness (investment)
Alternative assets do not usually have factor exposures that mirror traditional assets
3.3 - Multi-Factor Equity Pricing Models
List and Explain
2 challenges
of empirical multifactor models
and explain
why multifactor models are suitable for
Alternative Investments
3.3 - Multi-Factor Equity Pricing Models
1. False Identification of Factors
Analyst can find ~5 significant factors out of hundreds, but they can be useless. Make sure that factors have both a theoretical and a statistical reason to be included in a model.
2. Factor Return Correlation vs. Causation
Factors can be correlated, but might not predict future returns for various reasons
The Need for a CAPM Alternative
Alternative investments 1) returns not normally distributed, 2) have heterogeneous expectations
Nontraditional asset classes often are not distributed normally - while single-factor models (e.g., CAPM) assumes 1) all investors invest only in the market portfolio, 2) returns are normally distributed, 3) all investors have homogenous expectations and time horizons
Alternative assets are well suited for multifactor models
3.3 - Multi-Factor Equity Pricing Models
List
10 most common factor premiums
(factor investing)
3.3 - Multi-Factor Equity Pricing Models
1. Value factor premium. This strategy involves taking a long position in (value) stocks with high book-to-market ratios and a short position in (growth) stocks with a low book-to-market ratio.
2. Size factor premium. This strategy involves taking a long position in small-cap stocks and a short position in large-cap stocks.
3. Momentum factor premium. This strategy involves taking a long position in the previous period’s winning stocks and a short position in the previous period’s declining stocks.
4. Liquidity factor premium. This strategy involves taking a long position in illiquid assets and a short position in assets that are similar but liquid.
5. Credit risk factor premium. This strategy involves taking a long position in bonds with low credit quality and a short position in bonds with high credit quality.
6. Term factor premium. This strategy involves taking a long position in long-term bonds and a short position in short-term bonds.
7. Implied volatility factor premium. This strategy involves taking a long position in realized volatility through delta hedging and a short position in implied volatility.
8. Low volatility factor premium. This strategy involves taking a long position in low-volatility stocks and a short position in high-volatility stocks. This strategy can also be implemented using beta.
9. Carry trade factor premium. This strategy involves taking a long position in bonds for countries with high relative interest rates and a short position in bonds for countries with low relative interest rates.
10. Roll factor premium. This strategy involves taking a long position in commodities in backwardation and a short position in commodities in contango.
3.3 - Multi-Factor Equity Pricing Models
List
2 Issues
related to risk allocation
in Factor investing
3.3 - Multi-Factor Equity Pricing Models
- Passive benchmarks not available (passive weight not possible with short position)
- No passive weight => Active management is required (ETF will use some degree of active management)
3.3 - Multi-Factor Equity Pricing Models
List
4 Challenges
to Factor investing
3.3 - Multi-Factor Equity Pricing Models
- Global adoption is not likely (assets with limited short selling)
- Extreme positions. Investors limited on short selling
- Costs associated
- Factors usually come in bundles, which may yield undesired exposures
3.3 - Multi-Factor Equity Pricing Models
Describe
AMH - Adaptive Markets Hypothesis
and its implications
3.3 - Multi-Factor Equity Pricing Models
As competition increases, some market participants will adapt and thrive, while others will disappear
Profit opportunities are more prevalent when competition is lower.
Example: hedge funds
Implications:
* Time-varying premiums. The risk-return tradeoff is nonconstant over time (i.e., risk premiums change).
* Varying Market efficiency. Market efficiency exists on a continuum, ranging from fully efficient to fully inefficient.
* Adaptation. Trading strategies must adapt and evolve in keeping with the market environment.
* Degradation of alpha. Over time, innovation and competition will transform alpha into beta. While persistent alpha is not possible, temporary alpha opportunities do exist.
3.3 - Multi-Factor Equity Pricing Models
Quote
Time-varying volatility models
3.3 - Multi-Factor Equity Pricing Models
Both stochastic process
-
Heston model
similar to Black-Scholes model
(with volatility = mean reverting ). Captures time-varying volatility with a mean-reverting stochastic process, accounting for the leverage effect through correlation. -
Bates model
permits price jumps in random intervals and magnitudes. Extends the Heston model by adding jumps to the asset price process, providing a more comprehensive framework for capturing both continuous and discontinuous movements in asset prices.
3.3 - Multi-Factor Equity Pricing Models
Formula
The Present Value of Stochastic Discount Factors
3.3 - Multi-Factor Equity Pricing Models
PV = E[(π’u’ × m’u’ × x’u’) + (π’d’ × m’d’ × x’d’)]
π’u’ = the probability of the up state
π’d’ = the probability of the down state
m = stochastic discount factor
x = cash flow
3.3 - Multi-Factor Equity Pricing Models
List
Reasons to use stochastic discounting
(by alt managers who use multifactor models)
3.3 - Multi-Factor Equity Pricing Models
- Multifactor models offer exposure to unique risk factors.
- Cash flows in good times may be valued differently than cash flows in bad times.
- Alternative investors have different needs (i.e., constraints, time horizons, exposure to illiquid assets), which present different risk premiums.
3.3 - Multi-Factor Equity Pricing Models
Define
Smart beta strategies
3.3 - Multi-Factor Equity Pricing Models
Strategies to invest in ETFs with factors such as value, volatility, momentum, size, roll.
3.3 - Multi-Factor Equity Pricing Models
