Encyclopedia of Financial Models II

Factor Models

GUOFU ZHOU, PhD

Frederick Bierman and James E. Spears Professor of Finance, Olin Business School, Washington University in St. Louis

FRANK J. FABOZZI, PhD, CFA, CPA

Professor of Finance, EDHEC Business School

Abstract: Asset pricing models seek to estimate the relationship between the factors that drive asset expected return. The factors that drive the expected returns are referred to as risk factors. Two well-known asset pricing models returns are the capital asset pricing model and the arbitrage pricing theory. The relationship between risk factors and expected return in these two equilibrium models is based on various assumptions. In practice, multifactor models are estimated from observed asset returns and sophisticated statistical techniques are employed to estimate the exposure of an asset to each factor.

Given a set of assets or asset classes, an important task in the practice of investment management is to understand and estimate their expected returns and the associated risks. Factor models are widely used by investors to link the risk exposures of the assets to a set of known or unknown factors. The known factors can be economic or political factors, industry factors or country factors, and the unknown factors are those that best describe the dynamics of the asset returns in the factor models, but they are not directly observable or easily interpreted by investors and have to be estimated from the data.

Applications of the mean-variance analysis and ...