Compare macro-economic and fundamental factors models Flashcards
What are they
Macroeconomic Factor Models (Macroeconomic-Based Risk Factor Models): Risk factors are viewed as macroeconomic.
- Fundamental Factor Models (Microeconomic-Based Risk Factor Models): Risk factors are viewed at a microeconomic level by focusing on relevant characteristics of the securities themselves.
Macro econ explained
The factors are surprises in macroeconomic variables that significantly explain returns.
n the example of equities, the factors can be understood as affecting either the expected future cash flows of companies or the interest rate used to discount these cash flows back to the present.
Among macroeconomic factors that have been used are interest rates, inflation risk, business cycle risk, and credit spreads
Chen, Roll, and Ross (1986, Journal of Business)
Returns are governed by a set of economic influences.
In addition to the market factor, use economic variables to represent systematic factors explaining the returns of financial assets.
Estimate beta (systematic risk) by time series regression unlike fundamental factor models which rely on empirical findings such as firm size and a cross-sectional regression
Fundamental explained
the book-value-to-price ratio, – market capitalization, – the price-to-earnings ratio, and – financial leverage
Farma and French: three factor model
Market return
Size effect
Book-to-market value
Three steps:
Identify the factors: a reasonable short list of factors.
Estimate factor premia (F): the expected risk premium on each of these factors.
Measure the sensitivity of each stock to the factor (β)
Carhart 1997
developed a four-factor model by including a risk factor accounting for firms with positive past returns to produce positive future returns shown by MOM = momentum factor
Factors in fundamental
A fundamental factor model uses observed company attributes as factor betas. The factors in a fundamental factor model are the realized returns to a set of mimicking portfolios designed to capture the marginal returns associ- ated with a unit of exposure to each attribute
Connor 1995
Connor (1995) found that the risk attributes in the fundamental factor model capture all the risk characteristics captured by the macroeconomic fac- tor betas and how corporate characteristics or industry categories are related to return sensitivity to various macroeconomic shocks
Problems with fundamental
Equities are more sensitive to GDP growth. Assets such as Fixed Income (AGG), Currency (DX), and Gold are more sensitive to the inflation rate, in line with macroeconomic intuition.
