Factor Models and the Arbitrage Pricing Theory
11 important questions on Factor Models and the Arbitrage Pricing Theory
What are macroeconomic variables?
- Changes in interest rates
- inflation and productivity
What is meant with firm specific components?
What is factor risk?
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Why is the arbitrage pricing theory developed?
What is meant with factor betas or factor sensitivities?
What is systematic (market) risk?
What are the three different ways to construct factors?
- Factor analysis
- macroeconomic variables
- firm characteristics
What is a factor analysis and what are the advantages and disadvantages?
Advantages:
Provides the best estimates of the factors, given its assumptions
Disadvantages:
The assumption that covariances are constant is crucial and is probably violated in reality. And does not 'name' the factors
What is a macroeconomic variable and what are the advantages and disadvantages?
Advantages:
It provides the most intuitive interpretation of the factors.
Disadvantages:
Implies that the appropriate factors are the unanticipated changes in the macro variables.
What is a firm characteristic and what are the advantages and disadvantages?
Advantages:
More intuitive than the other two; formation does not require constant covariances.
Disadvantages:
Portfolios selected on the basis of past return anomalies, which are factors only because they explain historical 'accidents', may not be good at explaining expected returns in the future.
What are multifactor portfolio betas?
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