CAIA 48 - 55

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Compare a factor with an arbitrage opportunity.

A source of return that is a legitimate factor should perform poorly during "bad" times and "good" during normal times. If a source of return performs well in both "bad" and "good" times, it's an arbitrage opportunity.

Regarding factor investing, list the three important observations as described by Ang (2014).

Ang (2014) observes that: factors matter, not assets; assets are bundles of factors; and different investors should focus on different factors.

What are the three challenges associated with empirical multi-factor models?

False identification of factors, factor return correlation vs. causation, and justifying why the CAPM may not be sufficient.

What are the three steps of an empirical factor model?

First, the risk-free rate is subtracted from the returns of each security to form an excess return, which is used as the dependent variable; Second, the researcher selects a set of potential factors that serve as independent variables; Third, statistical analysis is used to identify those factors that are significantly correlated with returns.

Why are stochastic discount factors important for a portfolio that includes alternative investments?

In a multi-factor portfolio that includes alternative investments, different pieces of the portfolio will require different types of multi-factor methods, such as recognizing that cash flows must be valued differently depending on good vs. bad times and differently based on time horizons, different liabilities, and illiquidity profiles.

Adaptation for Success and Survival

It is necessary to use adaptable investment approaches to handle changes in the market environment. Opportunities are not always found in the same place; therefore, trading strategies must be altered as the economic environment evolves.

List the three major categories of factors that drive asset returns.

Macroeconomic factors, fundamental/style/investment/dynamic factors, and statistical factors.

Market Efficiency is a Relative Concept.

Market efficiency should be measured and discussed in relative terms as opposed to absolute terms. Market efficiency is a continuum; it is not simply efficient or inefficient, and a market displays varying degrees of efficiency at different points in time and for different market participants.

What factor is contained in the Fama-French-Carhart model that is not contained in the Fama-French model?

Momentum

What advantage do multi-factor models have over single-factor models, such as the Capital Asset Pricing Model?

Multi-factor models tend to explain systematic returns much better than do single-factor models. By doing so, multi-factor models are generally believed to produce better estimates of idiosyncratic returns.

In theory, an investor could passively allocate to several factors that could produce attractive results, but how might they implement a more sophisticated approach to multi-factor investing?

Not all factor premiums are the same, so a sophisticated strategy would take advantage of these differences by allocating higher weights to factors that are believed to be offering more attractive risk premiums.

What are two examples of bond factors? Describe both.

The credit risk premium and the term premium. The credit risk strategy takes long positions in bonds with low credit quality and short positions in bonds with high credit quality. The term strategy takes long positions in long-term bonds and short positions in short-term bonds.

Time-Varying Risk Premiums

The tradeoff between risk and return is not stable over time (risk premiums vary over time). In addition, changes in risk premiums could be predicted based on technical and fundamental variables.

The Inevitable Degradation of alpha

With time, what was once alpha becomes, due to innovation and competition, beta. Persistent alpha opportunities are not possible; however, fleeting alpha opportunities may be possible.

Fama-French-Carhart model

adds a fourth factor to the Fama-French model: momentum.

The Fama-French five-factor model

adds two factors to the Fama-French three-factor model: robust minus weak, and conservative minus aggressive.

The Heston model

allows the volatility of the asset to change randomly through time in a continuous process that reverts to a long-term average

Adaptive Markets Hypothesis (AMH)

an approach to understanding how markets evolve, how opportunities occur, and how market players succeed or fail based on principles of evolutionary biology...."Prices reflect as much information as dictated by the combination of environmental conditions and the number and nature of "species" in the economy, or ... ecology. Species are defined as distinct groups of market participants: e.g., pension funds, retail investors, hedge funds..."

Statistical factors

distinguished by having been identified purely on empirical characteristics rather than style or economic characteristics. For example, principal component analysis of security returns through time may find that much of the return differences between assets can be explained by perhaps three to five components. The economic identity of these factors and economic cause of the relation between the factor and the asset returns is often not known

ex poste vs ex ante

ex ante models describe expected returns while ex post models describe realized returns.

Multi-factor models

express systematic risk using multiple factors and are extremely popular throughout traditional and alternative investing. The reason is simple: multi-factor models tend to explain systematic returns much better than do single-factor models.

Multi-factor models of asset pricing

express systematic risk using multiple factors and are extremely popular throughout traditional and alternative investing. The reason is simple: multi-factor models tend to explain systematic returns much better than do single-factor models. By doing so, multi-factor models are generally believed to produce better estimates of idiosyncratic returns.

Fama-French model

links the returns of assets to three factors: (1) the market portfolio; (2) a factor representing a value versus growth effect; and (3) a factor representing a small-cap versus large-cap effect.1

Macroeconomic factors

macroeconomic factors related to asset returns throughout the entire economy and across asset classes, and include productivity, inflation, credit, economic growth, and liquidity

A momentum crash

occurs when those assets with recent overperformance (i.e., those assets with momentum) experience extremely poor performance relative to other assets (Asness et al. 2010).

a tradable asset

position that can be readily established and liquidated in the financial market, such as a stock position, a bond position, or a portfolio of liquid positions. Alternatively, the factors may represent non-tradable variables, such as inflation or economic productivity.

Conservative minus aggressive

the average return on... conservative investment portfolios minus the average return on... aggressive investment portfolios

Robust minus weak factor

the average return on... robust operating profitability portfolios minus the average return on... weak operating profitability portfolios.

Time-varying volatility

the characteristic of a return series in which the asset's returns experience varying levels of true (as opposed to realized) return variation.... which simply means that the asset's volatility is not constant

Fundamental, style, investment, or dynamic factors

these drive equity returns within asset classes and include well known style factors such as value, size, momentum, quality, and low volatility. These factors are linked to fundamental firm attributes that have been empirically identified as being important drivers of different investment returns across various firms, industries, and sectors. These factors are used in smart beta and alternative beta approaches.

The Bates model

treats volatility as a stochastic process much like the Heston model except that it includes a jump process for the underlying asset's price that permits price jumps at random time intervals and with random magnitude. The modeling process comes down to a decision of whether random changes in equity prices through time are driven purely by a volatility process that is itself random or whether the price changes are also the result of random price shocks.

Stochastic discount factors (pricing kernels)

used in asset valuation models to allow the present value of each cash flow (across each potential economic state) to be formed with potentially different discount rates rather than imposing that all potential cash flows be discounted with the same rate. For example, consider a one-period zero coupon bond with two potential cash flows: $100 in the no-default state and $50 in the default state. A stochastic discount factor approach would allow each potential cash flow to be discounted with its own factor based on the economic state in which it occurs, rather than imposing that the expected value of the bond's cash flow be discounted by a single factor.

ex ante form of the Fama-French model:

where Rs is the return to a diversified portfolio consisting of small-capitalization stocks, Rb is the return to a diversified portfolio consisting of big-capitalization stocks, β1i is the responsiveness of asset i to the spread (Rs − Rb), Rh is the return to a diversified portfolio consisting of high book-to-market ratio (value) stocks, Rl is the return to a diversified portfolio consisting of low book-to-market ratio (growth) stocks, and β2i; is the responsiveness of asset i to the spread (Rh − Rl).

Fama-French-Carhart model ex ante

where Rw is the return to a diversified portfolio consisting of winning stocks, in the sense that they have better performance over a previous period; Rd is the return to a diversified portfolio consisting of declining stocks, in the sense that they have worse performance over a previous period; and β3i is the responsiveness of asset i to the spread (Rw − Rd).

Describe the four practical implications of an adaptive view on markets.

1) The tradeoff between risk and return is not stable over time and risk premiums can be predicted based on technical and fundamental variables 2) Market efficiency is a relative concept instead of an absolute one, and a market displays varying degrees of efficiency depending on the point in time and the participant. 3) It is necessary to use adaptable investment approaches to handle changes in the market environment. 4) With time, alpha becomes beta due to innovation and competition.

A factor

A factor represents a unique source of return and a unique premium in financial markets such that the observed return cannot be fully explained by other factors. In other words, return factors are not supposed to be highly correlated with each other.


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