Multi-Factor Models
This chapter is devoted to estimating various factor models. Factors are variables/attributes that in the past were correlated with (then future) stock returns and are expected to contain the same predictive signals in the future.
These risk factors can be considered a tool for understanding the cross-section of (expected) returns. That is why various factor models are used to explain the excess returns (over the risk-free rate) of a certain portfolio or asset using one or more factors. We can think of the factors as the sources of risk that are the drivers of those excess returns. Each factor carries a risk premium and the overall portfolio/asset return is the weighted average of those premiums.
Factor models play a crucial role in portfolio management, mainly because:
- They can be used to identify interesting assets that can be added to the investment portfolio, which—in turn—should lead to better-performing portfolios.
- Estimating...
