Pairs Trading: Quantitative Methods and Analysis

CHAPTER 3

Factor Models

INTRODUCTION

Factor models are models that are used to explain the risk/return characteristics of assets. It is actually a rather loose term that serves to describe a wide variety of models. However, all the models share the common characteristic that they may be viewed as extensions to the CAPM model. The premise of the CAPM model is that the returns of assets are explicable almost completely by the behavior of the overall market. Each asset is sensitive to the market in its own characteristic way, and this sensitivity is termed beta.

Thus in the CAPM model there is a single explanatory factor and exposure value; namely, the market return and beta. A natural extension to this idea would then be to have multiple explanatory factors and exposure/sensitivity values. For instance, it is possible to construe that the return on a stock depends on the sector of the economy in which it operates, the market capitalization, and a good number of other explanatory factors that can be drawn from the available repertoire of market variables. In this context of multiple explanatory factors, the return of a stock would then be an aggregate of the return contributions of the factors scaled according to the sensitivity /factor exposure. Thus, the return of a stock in a factor model is explained by the return contributions of the various factors.

Depending on the type ...