ECF350/BAS430

o The multifactor models of asset returns:

 macroeconomic models
 fundamental factor models
 statistical factor models
o The single index model of asset returns
o Diversifiable and non-diversifiable risk
o Construction of the different types of multifactor
models
o Mathematical applications using single and
multifactor models
Readings: (1) CT8 Exam Prep Manual Unit 6
 A multi-factor model is a combination of various
elements or factors that are correlated with asset
returns
 It is a financial model that employs multiple factors
in its calculations to explain market phenomena
and/or equilibrium asset prices
 A multi-factor model can be used to explain either
an individual security or a portfolio of securities
 It does so by comparing two or more factors to
analyse relationships between variables and the
resulting performance
 A multifactor model of security returns attempts to
explain the observed historical return by an equation
of the form:
𝑅𝑖 = 𝛼𝑖 + 𝑏𝑖,1 𝐼1 + 𝑏𝑖,2 𝐼2 + ⋯ + 𝑏𝑖,𝐿 𝐼𝐿 + 𝜀𝑖
Where,
 𝑅𝑖 is the return on security 𝑖
 𝛼𝑖 is the constant
 𝑏𝑖,𝑘 is the sensitivity of security 𝑖 to factor 𝑘
 𝐼𝑘 is the change in the kth factor which explain
the variation of 𝑅𝑖 about the expected return 𝛼𝑖
 𝜀𝑖 is the random term
 The k factors are the systematic factors that
influence the returns on every security
 The sum of the systematic factors, along with their
respective coefficients is called the systematic return
of security i and takes the form
𝑆𝑌𝑅𝑖 = 𝑏𝑖,1 𝐼1 + 𝑏𝑖,2 𝐼2 + ⋯ + 𝑏𝑖,𝐿 𝐼𝐿
 The sum of the remaining parts of the multi-factor
model, which are independent of the securities’
return is called the specific return of security i and
takes the form
𝑆𝑃𝑅𝑖 = 𝛼𝑖 + 𝜀𝑖
 The above means that the multifactor model of
security returns is the sum of the systematic returns
of security i and the specific return of security i
 i.e.
𝑅𝑖 = 𝑆𝑌𝑅𝑖 + 𝑆𝑃𝑅𝑖

 NOTE: The multi-factor model was built so as to

find a set of factors which explain as much as
possible the observed historical variation, without
introducing too much “noise” into the predictions of
future returns
Assumptions
 The expected value of the error term from security i
is zero
 i.e. 𝐸 𝜀𝑖 = 0
 The covariance between the error term from security
i and the error term from security j is zero
 i.e. 𝐶𝑜𝑣 𝜀𝑖 , 𝜀𝑗 = 0, 𝑓𝑜𝑟 𝑎𝑙𝑙 𝑖 ≠ 𝑗
 The covariance between the error term and the kth
factor is zero
 𝐶𝑜𝑣 𝜀𝑖 , 𝐼𝑘 = 0 𝑓𝑜𝑟 𝑎𝑙𝑙 𝑠𝑡𝑜𝑐𝑘𝑠 𝑎𝑛𝑑 𝑖𝑛𝑑𝑖𝑐𝑒𝑠
Model Expectation
 From the model, we can obtain the expected return

𝑅𝑖 = 𝛼𝑖 + 𝑏𝑖,1 𝐼1 + 𝑏𝑖,2 𝐼2 + ⋯ + 𝑏𝑖,𝐿 𝐼𝐿 + 𝜀𝑖

𝐸(𝑅𝑖 ) = 𝐸(𝛼𝑖 + 𝑏𝑖,1 𝐼1 + 𝑏𝑖,2 𝐼2 + ⋯ + 𝑏𝑖,𝐿 𝐼𝐿 ) + 𝐸(𝜀𝑖 )

𝐸(𝑅𝑖 ) = 𝛼𝑖 + 𝑏𝑖,1 𝐸(𝐼1 ) + 𝑏𝑖,2 𝐸(𝐼2 ) + ⋯ + 𝑏𝑖,𝐿 𝐸(𝐼𝐿 )

Example
Consider a two-factor model. If:
 the mean specific return is 1.0%
 the expected values of the two factors are 3.0%
and 2.2% and
 the sensitivities of investment returns to each of
the factors are 0.8 and –0.3 respectively.
What is the expected return predicted by the multi-
factor model?
Solution

𝐸(𝑅𝑖 ) = 𝛼𝑖 + 𝑏𝑖,1 𝐸(𝐼1 ) + 𝑏𝑖,2 𝐸(𝐼2 )

 𝛼𝑖 = 0.1, 𝑏𝑖,1 = 0.8, 𝑏𝑖,2 = −0.3, 𝐸 𝐼1 = 3, 𝐸 𝐼2 =
2.2
𝐸(𝑅𝑖 ) = 0.1 + 0.8 3 + (−0.3)(2.2)
𝐸(𝑅𝑖 ) = 2.74%

Therefore, the expected return as predicted by the

model is 2.74%
 These use observable economic time series as the
factors
 They could include factors such as the annual rates
of inflation and economic growth, short-term interest
rates, the yields on long-term government bonds,
and the yield margin on corporate bonds over
government bonds
 In these models, the factors are surprises in
macroeconomic variables that significantly explain
asset class returns
 Surprise in this regard is the difference between the
actual value and the forecasted value
 It is the error term we discussed earlier
 The expected value of the surprise is zero
 i.e. ε = 𝑅𝑖 − 𝑅𝑖

𝐸 ε = 𝐸 𝑅𝑖 − 𝑅𝑖 = 0
 The factors can be understood as affecting either
the expected future cash flows of companies or the
interest rate used to discount these cash flows back
to the present and are meant to be uncorrelated
 A related class of the model uses a market index
plus a set of industry indices as the factors
 Here, “industry” refers to the company sectors, such
as banking, energy, food, support services etc.
 So, security returns are assumed to reflect the
influence of both market-wide and industry-specific
effects
 Once the set of factors has been decided on, a time
series regression is performed to determine the
sensitivities for each security in the sample
 The regression model takes the form

𝑅𝑡 = 𝛼 + 𝑏𝑡,1 𝐼1 + 𝑏𝑡,2 𝐼2 + ⋯ + 𝑏𝑡,𝐿 𝐼𝐿 + 𝜀𝑡

 As before,
 𝐸 𝜀𝑖 = 0
 𝐶𝑜𝑣 𝜀𝑖 , 𝜀𝑗 = 0, 𝑓𝑜𝑟 𝑎𝑙𝑙 𝑖 ≠ 𝑗
 𝐶𝑜𝑣 𝜀𝑖 , 𝐼𝑘 = 0 𝑓𝑜𝑟 𝑎𝑙𝑙 𝑠𝑡𝑜𝑐𝑘𝑠 𝑎𝑛𝑑 𝑖𝑛𝑑𝑖𝑐𝑒𝑠
 One of the weaknesses of these models is that it is
difficult to know the number of factors to include in
the model
 Too many factors would result in the problem of
over-parameterized model
 A common method used is to start with relatively
few, perform the regression and measure the
residual (unexplained) variance
 An extra factor is then added and the regression
repeated
 The whole process is repeated until the addition of
an extra factor causes no significant reduction in the
residual variance
 An alternative approach is to start with a more
general model containing a large number of possible
factors
 Then remove those factors whose elimination does
not significantly affect the explanatory power of the
model – i.e. the size of the residual variance
 Fundamental factor models are closely related to
macroeconomic models but instead of (or in addition
to) macroeconomic variables the factors used are
company-specific variables
 These may include such fundamental factors as:
 the level of gearing
 the price earnings ratio
 the level of R&D (research & development)
spending
 the industry group to which the company belongs
 Some models are also constructed in relation to the
benchmark model
 This is done to compare portfolio performance with
the performance of the benchmark portfolio
 Suppose that you can find a portfolio that has
similar sensitivities to similar factors as a
benchmark portfolio
 Then by holding that portfolio you should be able
to closely replicate the performance of the
benchmark
 Statistical factor models do not rely on specifying the
factors independently of the historical returns data
 Instead a technique called principal components
analysis can be used to determine a set of indices
which explain as much as possible of the observed
variance
 However, these indices are unlikely to have any
meaningful economic interpretation and may vary
considerably between different data sets
 Principal components analysis is a technique used to
investigate the relationship between a set of
endogenous variables, such as the factors
determining the investment return in a multifactor
model
 The approach can be used to;
 determine the relative significance of the various
factors
 combine groups of highly correlated factors into
single factors or principal components that are
much less highly correlated with each other
 Note that selection of optimal portfolio requires that
the factors used are Orthogonal (Uncorrelated)
 How can we make the statistical models have
economic interpretation?
 If the factors are derived from a set of market
indices or macroeconomic variables then we can
transform the original set into an orthogonal set
which retain a meaningful economic interpretation
Transformation of macroeconomic variables into
Orthogonal sets
 Consider two indices, 𝐼1 and 𝐼2 where 𝐼1 is captured
from the market indices while 𝐼1 is captured from the
industry indices. Suppose further that the two-factor
model takes the form
𝑅𝑖 = 𝛼𝑖 + 𝑏𝑖,1 𝐼1 + 𝑏𝑖,2 𝐼2 + 𝜀𝑖
 Since the two models are correlated, we are likely to
face the problem of serial correlation in the model
 To counter this, we can transform the correlated
indices into uncorrelated indices
Transformation of macroeconomic variables into
Orthogonal sets – Steps
 Step 1: Pick one index as a focus index
 i.e. Let 𝐼1 = 𝐼1∗
 This changes the model to
𝑅𝑖 = 𝛼𝑖 + 𝑏𝑖,1 𝐼1∗ + 𝑏𝑖,2 𝐼2 + 𝜀𝑖
 Step 2: Regress 𝐼2 on 𝐼1∗ to obtain the best fit for
the two variables
 In this stage, 𝐼2 is the dependent variable while
𝐼1∗ is the independent variable
 𝐼2 = 𝛾1 + 𝛾2 𝐼1∗ + 𝑑
Transformation of macroeconomic variables into
Orthogonal sets – Steps
 From the model 𝐼2 = 𝛾1 + 𝛾2 𝐼1∗ + 𝑢
 𝛾1 is the constant
 𝛾2 is the slope of the regression line
 𝑢 is the error term and 𝐸 𝑢 = 0

 Step 3: From the equation obtain in step 2, make 𝑢

subject of the formula to have
𝑢 = 𝐼2 − (𝛾1 + 𝛾2 𝐼1∗ )
 Step 4: Set 𝑢 equal to 𝐼2∗
Transformation of macroeconomic variables into
Orthogonal sets – Steps
 Note that 𝐼2∗ is not correlated with 𝐼1
 Meaning that 𝐶𝑜𝑣(𝐼2∗ , 𝐼1 ) = 0
Task
A modeller has developed a two-factor model to explain
the returns obtained from security i. It has the form:
𝑅𝑖 = 2 + 1.3𝐼1 + 0.8𝐼2 + 𝜀𝑖
However, he is concerned that the two indices 1 and 2
may be correlated and so decides to re-express the
model in terms of orthogonal factors. He therefore
regresses Index 1 on Index 2 and obtains the following
equation for the line of best fit:
𝐼1 = 0.8 + 0.3𝐼2
Use this information to re-express the two-factor model
in terms of two orthogonal factors 𝐼1∗ and 𝐼2∗