CHAPTER 14Factor Models
In Chapters 7 to 10 and 12 we discussed the CAPM and the APT as models of asset pricing. We discussed how to estimate the elements of the CAPM using regression analysis and how to use the parameters in risk-adjusted return measures. Here we will begin to delve into “factor models,” which are extensions of the earlier ideas. The central idea of factor models is that an asset’s return can be described and explained in terms of the asset’s characteristics, which determine its sensitivities to various economic and financial risks that are pervasive within the asset class.
THE SINGLE INDEX MODEL
Consider the market model regression often used to estimate elements of the CAPM:
ri = return Ri of asset i minus the risk-free ...