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Encyclopedia of Financial Models II by Frank J. Fabozzi

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Factor-Based Equity Portfolio Construction and Analysis

PETTER N. KOLM, PhD

Director of the Mathematics in Finance Masters Program and Clinical Associate Professor Courant Institute of Mathematical Sciences, New York University

JOSEPH A. CERNIGLIA

Visiting Researcher, Courant Institute of Mathematical Sciences, New York University

FRANK J. FABOZZI, PhD, CFA, CPA

Professor of Finance, EDHEC Business School

Abstract: A factor is a common character among a group of assets. In the equities market, for example, it could be a particular financial ratio such as the price-earnings ratio or the book-price ratio. Factors fall into three categories—macroeconomic influences, cross-sectional characteristics, and statistical factors. Within asset management firms, factors and factor-forecasting models are used for a number of purposes. Those purposes could be central to managing portfolios. Within a trading strategy, for example, factors determine when to buy and sell securities. Factors are employed in other areas of financial theory, such as asset pricing, risk management, and performance attribution.

Common stock investment strategies can be broadly classified into the following categories: (1) factor-based trading strategies (also called stock selectiont or alpha models), (2) statistical arbitrage, (3) high-frequency strategies, and (4) event studies. Factors and factor-based models form the core of a major part of today’s quantitative trading strategies. The focus of this entry is ...

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