Chapter 7: Models of asset returns

Question 1

Why is Modern Portfolio Theory difficult to implement in practice

Answer 1

• Large data requirements
• Computational difficulty

Question 2

Macroeconomic factor models

Answer 2

• Uses economic variables as factors
• A coomon method is to start with relatively few factors, add factors if the addition produces significant decrease in the residual variance

Question 3

Fundamental factor models

Answer 3

• Use company specific variables as factors

Question 4

Statistical factor models

Answer 4

• Do not rely on specifying factors independently of historical data
• Uses PCA to identify indicies that explain the most of the observed variance
• Unlinkely to have economic interpretation and may vary between data sets

Question 5

Systematic return

Answer 5

The element of the total return that arises due to the influence of the L factors that affect the returns of every security

Question 6

Specific return

Answer 6

The element of the total return that arises independent of the L factors that affect every security, and hence is independent of the returns of other securities

Question 7

Main uses of single factor and multifactor models

Answer 7

• Determination of efficient frontier
• Risk control
• Performance analysis
• Catergorisation of investment styles