R39: Multifactor Models

Question 1

Factor

Answer 1

-a variable or characteristic with which individual asset returns are correlated

Question 2

What is CAPM

Answer 2

• a kind of single factor model

- in equlibrium

Question 3

Equity Risk Premium

Answer 3

risk factor return

systematic or market risk

Question 4

Why is CAPM an incomplete description of risk

Answer 4

• small cap outperforms large cap
• value outperforms growth
• momentum exists

Question 5

Intercept in a multifactor model

Answer 5

-this is the expected return of the asset E(Ri), if all the factor premiums F are 0

Question 6

correlations between all the factors in a multifactor model

Answer 6

the correlations between them all are 0

Question 7

3 key assumptions of multi factor models

Answer 7

• factor model describes asset returns
• with many assets, investors can form well diversified portfolios that eliminate asset specific risk
• no arbitrage exists between well diversified portfolios.

Question 8

Arbitrage pricing theory

Answer 8

given a set of expected returns and factor sensitivities, you can create linear equations to solve for the betas and risk free rates. If no arbitrage holds, that equation can be used to price any well diversified portfolios

Question 9

Carhart model

Answer 9

• model for excess return on a portfolio above the risk free rate.
• alpha
• RMRF-return on a value weighted index minus one month t-bill rate
• HML-average return on 2 high BV/MV portfolios minus average return on 2 low BV/MV portfolios
• WML-past 12 month’s winners (top 30%) minus 12 months losers (bottom 12%)

Question 10

Macroeconomic factor model

Answer 10

• the factors are surprises in economic variables.

- if the actual variable turns out to be the expected value, it was already reflected in the expected value.

Question 11

fundamental factor model

Answer 11

-attributes of stocks or companies (BV/MV, market cap, E)

Question 12

statistical model

Answer 12

-applied to historical returns to extract factors

-

Question 13

two components of portfolio active risk

Answer 13

• Active factor risk: contribution to active risk resulting from the portfolio’s different-from-benchmark exposures to factors (factor sensitivity in the portfolio different from the benchmark)
• Active specific risk or security selection risk: measures the active non-factor or residual risk assumed by the manager (Security weightings in the portfolio different from the benchmark).

Question 14

Difference between macroeconomic and fundamental factor models

Answer 14

• macroeconomic: we develop factor (surprise) series first and then estimate the factor sensitivities through regression.
• fundamental: first specify the factor sensitivities (attributes) then estimate the factor returns through regression.

Question 15

Asset sensitivity to a factor (in fundamental factor model)

Answer 15

-expressed as a standardized beta

b = (value of attribute - average value of attribute)/(sd of attribute)