CHAPTER 6Fundamental Factor Models

In nature there is fundamental unity running through all the diversity we see about us.

—Mohandas Gandhi

6.1 INTRODUCTION

Recall from Chapter 3 the central idea of modern financial economics: The average return of a stock is the payoff for taking risk. In a factor model, the factor exposure represents the exposure of a stock to some kind of risk. The factor premium quantifies the payoff to an investor who takes on that risk by buying the stock. The average stock return therefore equals the product of the factor exposure and the factor premium:

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In the fundamental factor model, the factor exposure is known. It ...

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