FACTOR MODELS

(Chapter 6)

Markowitz Model
Employment of Factor Models
Essence of the Single-Factor Model
The Characteristic Line
Expected Return in the Single-Factor Model
Single-Factor Model’s Simplified Formula for
Portfolio Variance
Explained Versus Unexplained Variance
Multi-Factor Models
Models for Estimating Expected Return
 Markowitz Model
M M
σ 2 (rp )   x x Cov(r , r )
j1 k 1
j k j k

σ 2 (r ) Cov(r1 , r2 ) . . . Cov(r1 , rM ) 
 1 
Cov(r , r ) σ 2 (r2 ) . . . Cov(r2 , rM )
 2 1 
 . . . . 
 
 . . . . 
 2 
Cov(r M , r1 ) . . . . . . σ (rM ) 
Problem: Tremendous data requirement.
Number of security variances needed = M.
Number of covariances needed = (M2 - M)/2
Total = M + (M2 - M)/2
Example: (100 securities)
100 + (10,000 - 100)/2 = 5,050
Therefore, in order for modern portfolio theory to be usable for
large numbers of securities, the process had to be simplified.
(Years ago, computing capabilities were minimal)
Employment of Factor Models
To generate the efficient set, we need estimates of
expected return and the covariances between the
securities in the available population. Factor models
may be used in this regard.
Risk Factors – (rate of inflation, growth in industrial
production, and other variables that induce stock prices
to go up and down.)
May be used to evaluate covariances of return between
securities.
Expected Return Factors – (firm size, liquidity, etc.)
May be used to evaluate expected returns of the securities.
In the discussion that follows, we first focus on risk
factor models. Then the discussion shifts to factors
affecting expected security returns.
 Essence of the Single-Factor
Model
Fluctuations in the return of a security relative to that of
another (i.e., the correlation between the two) do not depend
upon the individual characteristics of the two securities.
Instead, relationships (covariances) between securities occur
because of their individual relationships with the overall
market (i.e., covariance with the market).
If Stock (A) is positively correlated with the market, and if
Stock (B) is positively correlated with the market, then Stocks
(A) and (B) will be positively correlated with each other.
Given the assumption that covariances between securities
can be accounted for by the pull of a single common factor
(the market), the covariance between any two stocks can be
written as:
Cov(rj , rk )  β jβk σ 2 (rM )
 The Characteristic Line
(See Chapter 3 for a Review of the Statistics)

Relationship between the returns on an individual

security and the returns on the market portfolio:
rj,t  A j  β jrM,t  ε j,t
rj,t is the rate of return on stock (j) during period (t)

Aj = intercept of the characteristic line (the expected

rate of return on stock (j) should the market happen
to produce a zero rate of return in any given period).

 j = beta of stock (j); the slope of the characteristic

line.

 j,t = residual of stock (j) during period (t); the vertical

distance from the characteristic line.
Graphical Display of the
Characteristic Line

rj,t
0.4

0.3

0.2 = j

0.1
Aj
0 rM,t
0 0.2 0.4 0.6
 The Characteristic Line
(Continued)
Note: A stock’s return can be broken down into two
parts:
Movement along the characteristic line (changes
in the stock’s returns caused by changes in the
market’s returns).
Deviations from the characteristic line (changes in
the stock’s returns caused by events unique to the
individual stock).
rj,t  A j  β jrM,t  ε j,t

Movement along the line: Aj + jrM,t

Deviation from the line: j,t
 Major Assumption of the Single-Factor
Model
There is no relationship between the residuals of one
stock and the residuals of another stock (i.e., the
covariance between the residuals of every pair of
stocks is zero).
Cov(ε j , ε k )  0
Stock j’s Residuals (%)
10

0 Stock k’s Residuals (%)

-10 0 10 20

-10
 Expected Return in the Single-Factor
Model
Actual Returns: rj,t  A j  β jrM, t  ε j,t
Expected Residual:
Given the characteristic line is truly the line of best
fit, the sum of the residuals
n
would be equal to zero
ε
t 1
j,t  0

Therefore, the expected value of the residual for

any given period would also be equal to zero:
E(ε j )  0
Expected Returns:
Given the characteristic line, and an expected
residual of zero, the expected return of a security
according to the single-factor model would be:
E(rj )  A j  β jE(rM )
 Single-Factor Model’s Simplified Formula for
Portfolio Variance
Variance of an Individual Security:
n
2
σ (rj )  
i 1
h i [rj,i  E(rj )]2

Given: rj,i  A j  β jrM, i  ε j,i

E(rj )  A j  β jE(rM )
It Follows That:
n
σ 2 (rj )   h ([A  β r
i 1
i j j M, i  ε j,i ]  [ A j  β jE(rM )])
2

n
= 
i =1
h i (β j[rM, i  E(rM )]  ε j,i ) 2

n
= 
i =1
h i (β 2j [rM, i  E(rM )]2  2 β j[rM, i  E(rM )] ε j,i  ε 2j,i )

n n n
= β 2j 
i =1
h i [rM, i  E(rM )]2  2 β j 
i 1
h i [rM,i  E(rM )] ε j,i  
i 1
h i ε 2j,i
Note: n
β 2j 
i =1
h i [rM,i  E(rM )]2  β 2jσ 2 (rM )

n n
2βj  h [r
i 1
i M,i  E(rM )] ε j,i  2 β j  h [r
i 1
i M, i  E(rM )][ε j,i  E(ε j )]

Since E(ε j )  0
= 2 β jCov(rM , ε j )
=0
Since Cov(rM , ε j ) is equal to zero for the
best fit line in simple regression .
n

i 1
h i ε 2j,i  σ 2 (ε j )  Residual Variance (See Chapter 3)

Therefore:
σ 2 (rj )  β 2jσ 2 (rM )  σ 2 (ε j )
 Variance of a Portfolio
Same equation as the one for individual security
variance: σ 2 (r )  β 2 σ 2 (r )  σ 2 (ε )
p p M p

Relationship between security betas & portfolio betas

m
βp  x β
j1
j j

Relationship between residual variances of stocks,

and the residual variance of a portfolio, given the
index model assumption.m
σ 2 (ε p )  
j1
x 2jσ 2 (ε j )

The residual variance of a portfolio is a weighted

average of the residual variances of the stocks in the
portfolio with the weights squared.
 Explained Vs. Unexplained Variance
(Systematic Vs. Unsystematic Risk)

Total Risk = Systematic Risk + Unsystematic

Risk
σ 2 (rj )  β 2jσ 2 (rM )  σ 2 (ε j )

Systematic: That part of total variance which

is explained by the variance in the market’s
returns.
Unsystematic: The unexplained variance, or
that part of total variance which is due to the
stock’s unique characteristics.
Note: Cov(rj , rM ) ρ j,M σ(rj ) σ(rM ) ρ j,M σ(rj )
βj   
2 2 σ(rM )
σ (rM ) σ (rM )
Therefore : β jσ(rM )  ρ j,M σ(rj )

β 2jσ 2 (rM )  ρ 2j,M σ 2 (rj )

[i.e., j22(rM) is equal to the coefficient of

determination (the % of the variance in the security’s
returns explained by the variance in the market’s
returns) times the security’s total variance]
Total Variance = Explained + Unexplained
σ 2 (rp )  βp2 σ 2 (rM )  σ 2 (ε p )
2 2 2
= ρp, M σ (rp )  σ (ε p )

As the number of stocks in a portfolio increases, the

residual variance becomes smaller, and the
coefficient of determination becomes larger.
 Explained Vs. Unexplained Variance
(A Graphical Display)

Residual Variance Coefficient of Determination

10 1.2

1
8

0.8
6
0.6
4
0.4

2
0.2

0 0
1 5 9 13 17 1 5 9 13 17
Number of Stocks Number of Stocks
 Explained Vs. Unexplained Variance
(A Two Stock Portfolio Example)
 β 2 σ 2 (r ) β Aβ Bσ 2 (rM )  σ 2 (ε ) Cov(ε A , ε B )
 A M   A 
β β σ 2 (r ) βB σ (rM ) 
2 2 Cov(ε , ε ) σ 2
(ε ) 
 B A M  B A B 
Covariance Matrix for Covariance Matrix for
Explained Variance Unexplained Variance

σ 2 (rp )  x 2Aβ 2Aσ 2 (rM )  x B

2 2 2
β Bσ (rM )  2 x A x Bβ Aβ Bσ 2 (rM )
Explained Variance
+ x 2Aσ 2 (ε A )  x B
2 2
σ (ε B )
Unexplained Variance
Assu ming Cov(ε A , ε B )  0
 Explained Vs. Unexplained Variance (A
Two Stock Portfolio Example) Continued
m
σ 2 (rp )  (x A β A  x Bβ B ) 2 σ 2 (rM )  
j1
x 2j σ 2 (ε j )

Explained Unexplained
2
 m  m

= 
 j=1

x jβ j  σ 2 (rM ) 


j =1
x 2j σ 2 (ε j )

= β p2 σ 2 (rM )  σ 2 (ε p )
If Cov(ε A , ε B )  0, residual variance will be understated .
If Cov(ε A , ε B )  0, residual variance will be overstated .
 A Note on Residual Variance
The Single-Factor Model assumes zero correlation
between residuals:
Cov(ε j , ε k )  0
In this case, portfolio residual variance is expressed
as: m
2 2 2
σ (ε p )   x σ (ε )
j1
j j

In reality, firms’ residuals may be correlated with each

other. That is, extra-market events may impact on
many firms, and: Cov(ε j , ε k )  0
In this case, portfolio residual variance would be:
m m m
σ 2 (ε p )  
j1
x 2jσ 2 (ε j )  2   x x Cov(ε , ε )
j1 k  j1
j k j k
 Markowitz Model Versus the Single-Factor Model
(A Summary of the Data Requirements)
Markowitz Model
Number of security variances = m
Number of covariances = (m2 - m)/2
Total = m + (m2 - m)/2
Example - 100 securities:
100 + (10,000 - 100)/2 = 5,050
Single-Factor Model
Number of betas = m
Number of residual variances = m
Plus one estimate of 2(rM)
Total = 2m + 1
Example - 100 securities:
2(100) + 1 = 201
 Multi-Factor
Models
Recall the Single-Factor Model’s formula for portfolio
variance:
σ 2 (rp )  βp2 σ 2 (rM )  σ 2 (ε p )
2 2 2
= ρp, M σ (rp )  σ (ε p )
If there is positive covariance between the residuals
of stocks, residual variance would be high and the
coefficient of determination would be low. In this case,
a multi-factor model may be necessary in order to
reduce residual variance.
A Two Factor Model Example
rj,t  A j  β g, jrg, t  β I, jrI,t  ε j,t
where: rg = growth rate in industrial production
rI = % change in an inflation index
 Two Factor Model Example -
Continued
Once again, it is assumed that the covariance
between the residuals of the the individual stocks are
equal to zero: Cov(ε j , ε k )  0
Furthermore, the following covariances are also
presumed: Cov(rg , ε j )  0
Cov(rI , ε j )  0
Cov(rg , rI )  0
Portfolio Variance in a Two Factor Model:

σ 2 (rp )  β g,
2
p σ 2
(rg )  β 2
I,p σ 2
(rI )  σ 2
(ε p )
 m
where: β g,p  x β
j1
j g, j

m
β I,p  x β
j1
j I, j

m
σ 2 (ε p )  
j1
x 2j σ 2 (ε j )

Assuming Cov(ε j , ε k )  0

Note that if the covariances between the residuals of

the individual securities are still significantly different
from zero, you may need to develop a different model
(perhaps a three, four, or five factor model).
 Note on the Assumption Cov(rg,rI ) =
0

If the Cov(rg,rI) is not equal to zero, the two factor

model becomes a bit more complex. In general, for
a two factor model, the systematic risk of a
portfolio can be computed using the following
covariance matrix:
g,p I,p
g,p  2 (rg ) Cov(r , r
g I  ) 

 2 
I,p   (rI ) 

 2 (rp )   g
2  2 (r )   2  2 (r )  2
,p g I, p I g, p I, p Cov (rg , rI )

To simplify matters, we will assume that the factors

in a multi-factor model are uncorrelated with each
other.
 Models for Estimating Expected
Return
One Simplistic Approach
Use past returns to predict expected future returns.
Perhaps useful as a starting point. Evidence
indicates, however, that the future frequently
differs from the past. Therefore, “subjective
adjustments” to past patterns of returns are
required.
Systematic Risk Models
One Factor Systematic Risk Model:

E(rj )  A j  β jE(rM )
Given a firm’s estimated characteristic line and an
estimate of the future return on the market, the
security’s expected return can be calculated.
 Models for Estimating Expected Return
(Continued)

Two Factor Systematic Risk Model:

E(rj )  A j  β1, jE(r1 )  β 2, jE(r2 )
N Factor Systematic Risk Model:
E(rj )  A j  β1, jE(r1 )  β 2, jE(r2 )  . . . + β N, jE(rN )

Other Factors That May Be Used in Predicting

Expected Return
Note that the author discusses numerous factors
in the text that may affect expected return. A
review of the literature, however, will reveal that
this subject is indeed controversial. In essence,
you can spend the rest of your lives trying to
determine the “best factors” to use. The following
summarizes “some” of the evidence.
 Other Factors That May Be Used in Predicting
Expected Return
Liquidity (e.g., bid-asked spread)
Negatively related to return [e.g., Low liquidity
stocks (high bid-asked spreads) should provide
higher returns to compensate investors for the
additional risk involved.]
Value Stock Versus Growth Stock
P/E Ratios
• Low P/E stocks (value stocks) tend to
outperform high P/E stocks (growth stocks).
Price/(Book Value)
• Low Price/(Book Value) stocks (value stocks)
tend to outperform high Price/(Book Value)
stocks (growth stocks).
 Other Factors That May Be Used in Predicting Expected
Return (continued)

Technical Analysis
Analyze past patterns of market data (e.g., price
changes) in order to predict future patterns of
market data. “Volumes have been written on this
subject.
Size Effect
Returns on small stocks (small market value) tend
to be superior to returns on large stocks. Note:
Small NYSE stocks tend to outperform small
NASDAQ stocks.
January Effect
Abnormally high returns tend to be earned
(especially on small stocks) during the month of
January.
 Other Factors That May Be Used in Predicting Expected
Return (continued)

And the List Goes On

If you are truly interested in factors that
affect expected return, spend time in the
library reading articles in Financial Analysts
Journal, Journal of Portfolio Management,
and numerous other academic journals.
This could be an ongoing venture the rest
of your life.
 Building a Multi-Factor Expected Return Model:
One Possible Approach

Estimate the historical relationship between return

and “chosen” variables. Then use this relationship to
predict future returns.
Historical Relationship:
rt  a 0  a1 (P/E Ratio)t 1  a 2 (Firm Size)t 1
+ a 3 (Beta)t 1  . . .

Future Estimate:

rt 1  a 0  a1 (P/E Ratio)t  a 2 (Firm Size)t

+ a 3 (Beta)t  . . .
 Using the Markowitz and Factor Models
to Make Asset Allocation Decisions

Asset Allocation Decisions

Portfolio optimization is widely
employed to allocate money between
the major classes of investments:
• Large capitalization domestic stocks
• Small capitalization domestic stocks
• Domestic bonds
• International stocks
• International bonds
• Real estate
 Using the Markowitz and Factor Models
to Make Asset Allocation Decisions
Continued:
Strategic Versus Tactical Asset Allocation
Strategic Asset Allocation
Decisions relate to relative amounts invested
in different asset classes over the long-term.
Rebalancing occurs periodically to reflect
changes in assumptions regarding long-term
risk and return, changes in the risk tolerance
of the investors, and changes in the weights of
the asset classes due to past realized returns.
Tactical Asset Allocation
Short-term asset allocation decisions based on
changes in economic and financial conditions,
and assessments as to whether markets are
currently underpriced or overpriced.
 Using the Markowitz and Factor Models
to Make Asset Allocation Decisions
Continued
Markowitz Full Covariance Model
Use to allocate investments in the portfolio among the
various classes of investments (e.g., stocks, bonds,
cash). Note that the number of classes is usually rather
small.
Factor Models
Use to determine which individual securities to include
in the various asset classes. The number of securities
available may be quite large. Expected return factor
models could also be employed to provide inputs
regarding expected return into the Markowitz model.
Further Information
Interested readers may refer to Chapter 7, Asset
Allocation, for a more indepth discussion of this subject.
In addition, the author has provided “hands on”
examples of manipulating data using the PManager
software in the process of making asset allocation
decisions.