1. CHAPTER TEN FACTOR MODELS

2. FACTOR MODELS AND RETURN- GENERATING PROCESSES n FACTOR MODELS DEFINITION: a model of a return- generating process that relates returns on securities to the movement of one or more common factors

3. FACTOR MODELS AND RETURN- GENERATING PROCESSES n FACTOR MODELS assume returns of two securities are correlated in some way

4. FACTOR MODELS AND RETURN- GENERATING PROCESSES n FACTOR MODELS any unexplained aspects of a return are assumed to be 3 unique 3 uncorrelated with the unique aspect of other securities

5. THE MARKET MODEL n THE MARKET MODEL is a specific example of a factor model the general form may be written r i =  i, I  i, I r  i, I where the factor is the market index (I) r i is the i th return in the market

6. THE MARKET MODEL n TWO IMPORTANT FEATURES OF THE ONE-FACTOR MODEL THE TANGENCY PORTFOLIO DIVERSIFICATION

7. MULTIPLE-FACTOR MODELS n MULTIPLE FACTOR MODELS use more than one explanatory variable in the return-generating process

8. MULTIPLE-FACTOR MODELS n MULTIPLE-FACTOR MODELS some of these factors may include 3 THE GROWTH RATE OF GDP

9. MULTIPLE-FACTOR MODELS n MULTIPLE-FACTOR MODELS some of these factors may include 3 THE LEVEL OF INTEREST RATES

10. MULTIPLE-FACTOR MODELS n MULTIPLE-FACTOR MODELS some of these factors may include 3 THE YIELD SPREAD BETWEEN CERTAIN VARIABLES

11. MULTIPLE-FACTOR MODELS n MULTIPLE-FACTOR MODELS some of these factors may include 3 THE INFLATION RATE

12. MULTIPLE-FACTOR MODELS n MULTIPLE-FACTOR MODELS some of these factors may include 3 THE LEVEL OF OIL PRICES

13. MULTIPLE-FACTOR MODELS n SECTOR-FACTOR MODELS Assumption: 3 prices may move together for the same industry or economic sector

14. MULTIPLE-FACTOR MODELS n SECTOR-FACTOR MODELS sectors possible 3 utilities 3 transportation 3 financial

15. ESTIMATING FACTOR MODELS n THREE METHODS TIME-SERIES APPROACH CROSS-SECTIONAL APPROACH FACTOR-ANALYTIC APPROACH

16. ESTIMATING FACTOR MODELS n TIME-SERIES APPROACH BEGINNING ASSUMPTIONS:

17. ESTIMATING FACTOR MODELS n TIME-SERIES APPROACH BEGINNING ASSUMPTIONS: 3 investor knows in advance of the factors that influence a security's returns

18. ESTIMATING FACTOR MODELS n TIME-SERIES APPROACH BEGINNING ASSUMPTIONS: 3 investor knows in advance of the factors that influence a security's returns 3 the information may be gained from an economic analysis of the firm

19. ESTIMATING FACTOR MODELS n CROSS-SECTIONAL APPROACH BEGINNING ASSUMPTION

20. ESTIMATING FACTOR MODELS n CROSS-SECTIONAL APPROACH BEGINNING ASSUMPTION 3 Identify Attributes: estimates of a securities sensitivities to certain factors

21. ESTIMATING FACTOR MODELS n CROSS-SECTIONAL APPROACH BEGINNING ASSUMPTION 3 Identify Attributes: estimates of a securities sensitivities to certain factors 3 estimate attributes in a particular period of time

22. ESTIMATING FACTOR MODELS n CROSS-SECTIONAL APPROACH BEGINNING ASSUMPTION 3 Identify Attributes: estimates of a securities sensitivities to certain factors 3 estimate attributes in a particular period of time 3 repeat over multiple time periods to estimate the factor’s standard deviations and correlations

23. ESTIMATING FACTOR MODELS n FACTOR-ANALYTIC APPROACH BEGINNING ASSUMPTIONS: 3 neither factor values nor securities attributes are know

24. ESTIMATING FACTOR MODELS n FACTOR-ANALYTIC APPROACH BEGINNING ASSUMPTIONS

25. ESTIMATING FACTOR MODELS n FACTOR-ANALYTIC APPROACH BEGINNING ASSUMPTIONS: 3 neither factor values nor securities attributes are know 3 uses factor analysis approach

26. ESTIMATING FACTOR MODELS n FACTOR-ANALYTIC APPROACH BEGINNING ASSUMPTIONS: 3 neither factor values nor securities attributes are know 3 uses factor analysis approach 3 take the returns over many time periods from a sample to identify one or more significant factors generating covariances

27. END OF CHAPTER 10