Multificator

Multifactor Models and Valuation
1.
2.
3.
4.
Problems with CAPM and Multifactor Models

Motivation: The 2 Factor Case
Asset Pricing: The Simplest Case
Overview of Uses
Session 09
Outline 09: Multifactor Models and Valuation
5. Optimal Portfolios
6. Tailoring Risk Exposures
7. Examples of Factor Models
Problems with CAPM and the Rise of Multifactor Models
Problem 1: Pricing anomalies (risk or irrationality?)

Strictly speaking CAPM cannot be rejected (because the Market portfolio is not observable; in practice,
we use proxies)
But applicable versions are at odd with data. Over the years accumulated evidence of pricing
anomalies:
Value Premium puzzle: firms with high Book-to-MKT ratios (value stocks) perform better
than those with low ratios (growth stocks)
Size Premium puzzle: Small firms do better than large firms
Mean reversion in long term returns (over-reaction)
Momentum in short term returns (under-reaction)
Accounting-based anomalies (accruals, pension funding, etc.)
Copyright Jos M. Marn
Portfolio Management
Session 09
Problem 2: CAPM-based portfolios are not economically intuitive

CAPM-based optimal portfolios are useless in the context of incomplete markets (individual risk).
Optimal portfolio of, say, a worker vs. a pension fund, should only differ on the exposure to the S&P?
In practice market portfolio does not exist, when using proxies we find that there are many other
sources of risk which are relevant for investors.
This means we need to set both the portfolio selection and the pricing problems in the context of
MULTIFACTOR MODELS.
Session 09
Motivation: The two factors case

As we mentioned before, a multifactor model can represent, for a universe of assets, multiple sources of
o common variation in (unexpected) returns
o risk premia present in (expected) returns
Initially, we use one- and two-factor models to simplify the analysis. In practice, many more factors are
often used.
The general form of a two-factor return-generating model, used to represent unexpected returns in period
t on a universe of N assets is
where:
Fkt : factor k
R it = ai + bi1F1t + bi 2 F2t + it
t = 1,...,T,
(1)
bik : sensitivity of asset is return to factor k
it : security specific (idiosyncratic) portion of the return on asset i

~ : used to emphasize that quantity is random
Session 09
The factors capture the common variation in the N assets, so

cov (it, jt) = 0 for i
(2)
j.
The general form of the corresponding two-factor pricing model, used to represent the sources of risk
premia in expected returns is
Ei = Rf + bi11 + bi22,
(3)
where denotes the premium associated with factor k.

Let us check the similarities between the one factor CAPM model (market model) and the bi-factorial
model we have just introduced:
One Factor Model

(CAPM)
2-Factor Model
Return Generating
Process
Asset Pricing
Formula
R%it = ai + bi R% Mt + %it
Ei = Rf + i ( Rf)
R%it = ai + bi1 F%1t + bi 2 F%2t + %it
Ei = Rf + bi11 + bi22
Session 09
Arbitrage Pricing (I) The Simplest Case

To illustrate how (3) obtains just using arbitrage arguments, lets consider the simplest possible case.
Assume
o each assets return is generated through time by a single random factor, F1t, and
o there are no idiosyncratic returns (its)
Rit = Ei + bi1F1t
(4)
If there are no arbitrage opportunities, then there must be a cross-sectional linear relation between Ei and
bi1 of the form
Ei = Rf + 1 bi1,
(5)
for some slope 1.
Ei
1
Rf
bi1
Session 09
The plot below indicates an arbitrage opportunity.

Ei
bi1
Example: Suppose that there are three assets with the following expected returns and sensitivities to the
factor:
bi1
Asset (i)
Ei
1
.07
0.5
2
.11
1.5
3
.10
1.0
If we pick any two of these assets and determine the line relating their Eis and bi1s, the other asset does
not lie on that line. For example, the line determined by assets 1 and 2 is
Ei = 0.05 + 0.04 bi1,
Session 09
but the point for asset 3 lies above that line.

There are a variety of ways to arbitrage in this case. For example, an equally weighted combination of
assets 1 and 2, call it portfolio p, has its expected return and b given by
Ep = 0.5E1 + 0.5E2 = 0.5(.07 + .11) = .09
(6)
bp1 = 0.5b11 + 0.5b21 = 0.5(0.5 +1.5) = 1.0.
(7)
Going long $1 of asset 3 and short $1 of portfolio p provides the payoff

R3t Rpt = (E3 + b31F1t) (Ep + bp1F1t)
= (.10 + 1 F1t) (.09 + 1 F1t)
= .01
(8)
which is a riskless arbitrage profit the random component of the return, F1t, has been hedged away.
If a riskless asset exists, it too must lie on the line relating Ei to bi1. Since its bi1 is zero, its expected return,
Rf, will be the intercept of the line, as we have written in (5).
More formally:
o Consider the following return generating process for three assets:
Session 09
Rit = Ei + bi1F1t i=1,2,3

o As we know, the economy exhibits arbitrage opportunities if it possible to find a portfolio with zero
cost and non-negative profits in the future and strictly positive in some states of the world.
o Let x=(x1, x2, x3) 0 be a zero cost portfolio (xi denotes the amount of $ invested in asset i), i.e.:
x1+ x2+ x3 = 0
(a)
o The return of this portfolio is:

Rpt = (E1x1 + E2x2+ E3x3) + (b11 x1 + b21 x2+ b31 x3)F1t
o Now, set x so that:
b11 x1 + b21 x2+ b31 x3 = 0
(b)
o In order for no arbitrage opportunities to exist, portfolio x must also satisfy:
Session 09
E1x1 + E2x2+ E3x3 = 0
(c)
o Now, basic knowledge of matrix algebra is enough to conclude that (a), (b) and (c), and x 0 imply
that there exists constants 0 and 1 such that:
Ei = 0 + 1 bi1 i= 1, 2, 3.
o Finally, if one of the assets is the risk free asset, it must be true that 0 = Rf. Hence,
Ei = Rf + 1 bi1
o This completes the proof of the equation (5).
So, for a general factor model:
R it = ai + bi1 F1t + bi 2 F2t +L+ biK FKt + it
t = 1,...,T,
(9)
We obtain the pricing formula:
E i = R f + bi11 + bi 2 2 +L+ biK K
(10)
Session 09
Overview of Uses
Applications of multifactor model include
o risk measurement and estimation
o risk management and hedging
o factor-neutral strategies
o trading and arbitrage
o portfolio optimization
o tailoring risk exposures
o style analysis
o performance evaluation
In fixed-income applications, it is often the case that
o the number of factors is small, typically one or two (sometimes three)
o the its are assumed to be zero
o the Fkts (factors) are prespecified as functions of observable variables
o the biks (sensitivities) change over time as functions of the factors
In equity applications, it is often the case that
o the number of factors is greater, typically three or more
o the its are not assumed to be zero
10
Session 09
o the Fkts may or may not be prespecified

o the biks are often assumed to
-
be constant, at least in the short run, or
change as functions of the firms characteristics
o the factors may or may not be prespecified
11
Session 09
Portfolio Choice: Mimicking Portfolios and Optimal Portfolios

The factors could be non-tradable assets (inflation, GNP growth, etc.)
Portfolios that hedge or mimic the factors are the basic components of various portfolio strategies.
The mimicking portfolio for a given factor is the portfolio with the maximum correlation with the factor.
Let R(k), t denote the return on the mimicking portfolio for the k-th factor, and let E(k) denote the portfolios
expected return.
The sensitivities (ciks) of each assets return to the mimicking-portfolio returns are the slopes in the regression
~
~
~
Rit R f = ai + ci1 ( R(1),t R f ) + ci 2 ( R( 2),t R f ) + u~it
(11)
The pricing relation can be written as

Ei = Rf +ci1(E(1) Rf) + ci2(E(2) Rf),
(12)
which implies ai = 0 in (11).

If all assets are correctly priced, then each investors portfolio should be some combination of cash and the
mimicking portfolios.
Other portfolios have the same level of expected return and sensitivities to the factor but greater variance.
12
Session 09
Example:
Suppose an investor instead holds a portfolio or security A, which is correctly priced.
The regression of portfolio As return on the mimicking-portfolio returns gives
~
~
~
R At R f = 0 + 0.5 ( R(1),t R f ) + 0.4 ( R( 2 ),t R f ) + u~At
(13)
An alternative portfolio P composed of

50% in mimicking portfolio 1
40% in mimicking portfolio 2
10% (100% - 50% - 40%) in cash
has the same expected return and factor sensitivities but lower variance.
13
Session 09
Tailoring Risk Exposures

Huge industry!!
By changing the allocations among the K factor-mimicking portfolios, an investors exposure to any of the risk
factors can be increased or reduced.
Examples:
A pension plan sponsor (corporation) whose cash flows are especially sensitive to the business cycle might
wish to have its pension fund take a lower, perhaps negative, exposure to an industrial-production factor. That
way, potential shortfalls in the pension fund would be less likely to occur in periods when the company is less
able to make additional contributions to the fund.
A sponsor of a plan with defined benefits that are indexed to inflation could take more exposure to an inflation
factor.
A financial corporation whose cash flows are especially sensitive to overall fluctuations in credit risk could
take less exposure to such a factor in its pension fund.
In the presence of such hedging concerns, investors do not necessarily attempt to maximize a Sharpe ratio
(INCOMPLETE MARKETS) nor hold portfolios passively.
A multifactor approach allows investors to assess the risk-reward tradeoff for each source of systematic factor
risk.
Implications for equilibrium
The tangent portfolio is some combination of the mimicking portfolios.
14
Session 09
The market portfolio is some, possibly different, combination of the mimicking portfolios.
In other words, the CAPM need not hold.
The relative demands by investors to tilt toward or away from a given source of risk determines E(k) Rf, the
premium for that factor.
If most investors prefer to tilt away from a given factor, then investors willing to tilt toward that factor will
receive a large premium.
15
Session 09
Popular Factor Models

Example (1): Specifying Macroeconomic Variables as Factors
The overall goal is to identify a set of macroeconomic factors that are associated with returns on financial assets.
The approach taken by Chen, Roll, and Ross (1986) is to view an assets price, Pt, as a stream of expected cash
flows, ct +1 ,ct + 2 , . . ., discounted at a rate k:
Pt =
ct +1
ct + 2
+
+ ...
1 + k ( 1 + k )2
(14)
One can then think of factors affecting price changes, or asset returns, as factor related either to changes in
expected cash flows or to changes in discount rates.
This reasoning led the authors ultimately to five factors:
1 monthly growth rate of industrial production
2 change in expected inflation
3 unexpected inflation
4 change in the risk premium
5 change in the term structure of interest rates
16
Session 09
The change in the risk premium is measured as the difference in returns between junk bonds (rated below BAA)
and long-term U.S. Government bonds.
The change in the term structure is measured as the difference in returns between long-term U.S. Government
bonds and U.S. Treasury Bills.
The return on the equally weighted portfolio of NYSE stocks is also included as a sixth factor.
17
Session 09
Example (2): Specifying Return Spreads as Factors

This is the most important for the purpose of this course
Simple approach to constructing a K-factor model: specify a set of K portfolio returns or return spreads.
The factors in a three-factor model proposed by Fama and French:
(RM,t Rf,t) :
the return on the market (value-weighted) in excess of the T-bill rate
S M Bt (Small minus Big) :
the return on small-cap stocks (bottom 50% of firms) minus the return on
large-cap firms (top 50%)
H M Lt (High minus Low) :
the return on high book-to-market stocks (top 30%) minus the return on low
book-to-market stocks (bottom 30%)
For each asset i, the sensitivities are the slopes (bi, si, hi) in the time-series regression,
Ri,t Rf,t = ai + bi(RM,t Rf,t) + si S M Bt + hi H M Lt + i,t.
(15)
The pricing relation is then

Ei Rf = bi[EM Rf] + si E {S M B} + hi E {H M L}
18
for all i
(16)
Session 09
When returns or return spreads on portfolios are used instead of non-traded factors, then an equivalent
representation of the pricing relation is
ai = 0
for all i
where ai is the intercept in the time-series regression in (15).
19
Session 09
Example (3): Specifying Firm Characteristics as Factor Sensitivities ($$$)

e.g., BARRA (here you have 3 pages of the 47 pages document describing BARRAs Methodology)
Phase I: Factor Loadings
Descriptor
Formulas
Fundamental
and
Market Data
Risk Index
Formulas
Descriptor
Risk Indices
BARRA
Industry
Allocation
Phase II: Factor Estimation
Asset Returns
Monthly
Cross-Sectional
Weighted
Regressions
Estimation
Universe
HICAP
Factor
Loadings
GLS
Weighting
20
Session 09
Phase III: Analysis
Factor
Returns
Covariance
Matrix
Specific
Returns
Specific
Risk
Forecast
Figure V1 Data Flow for Model Estimation

Figure V-1 depicts the model estimation process. The oval shapes mark the data flow throughout model estimation while the rectangular shapes show manipulations of and
additions to the data.
21
Session 09
The BARRA E2 Multiple-Factor Model

In the BARRA E2 Multiple-Factor Model, factors are estimated for 13 risk indices and for 55 industry groups. For 12 of these risk
indices and the 55 industry groups, the model is estimated, using generalized least squares weights, for our HICAP universe. This is
the universe of the 1000 largest capitalization companies, plus selected, slightly smaller companies to fill under-represented
industry groups. The universe has varied from 1170 to 1400 companies. The thirteenth risk index, the LOCAP, was introduced to fit
the model to the remaining 4500 or so stocks in our equity database.
Each risk index is built from a number of underlying fundamental data items that capture elements of risk. By combining them, we
produce a multifaceted measure of risk that best characterizes the single concept we are trying to measure. The individual data items
are called descriptors. The combined descriptors make up the risk index.
In the discussion below we list the descriptors for each index in order of decreasing importance. A plus sigh (+) shows that the
descriptor makes a positive contribution to the index, a minus sign (-) shows it makes a negative contribution.
For instance, in the Size (SIZ) index, the three descriptors are Capitalization, Total Assets (log), and Indicator of Earnings History.
The first, Capitalization, has a plus value, which indicates that the higher the capitalization of the company the greater the influence
on the index.
Risk Indices in the BARRA Equity Model
1. Variability in Markets (VIM)
The risk index is a predictor of the volatility of a stock based on its behavior and the behavior of its options in the capital markets. Unlike
beta, which measures only the response of a stock to the market, Variability in Markets measures a stocks overall volatility, with its
response to the market being but one source of volatility. A high beta stock, which shows a large change for every change in the market, will
necessarily have a high Variability in Markets. However, high Variability in Markets will not necessarily imply a high beta: the stock may be
responding to factors other than changes in the market.
This index uses measures such as cumulative trading range and daily stock price standard deviation to identify stocks with highly variable
prices. We use different formulas for three categories of stocks.
1. Optioned Stocks: All stocks having listed options.
2. Listed Stocks: All stocks in the HICAP universe that are listed on an exchange but do not have listed options.
22
Session 09
3. Thin Stocks: All stocks that are traded over the counter or are outside the HICAP universe, except those with listed options.
Optioned stocks are distinct for several reasons. First, the option price provides an implicit forecast of the total standard deviation of the
stock itself. Second, optioned stocks tend to be those with greatest investor interest and those with greatest effective trading volume. Stock
trading volume descriptors understate the effective volume because they omit option volume.
The thin stocks, about ten percent of the basic sample, are broken out because they tend to trade differently from other stocks. Over-thecounter stocks and other thinly traded securities show price behavior inconsistent with efficient and timely prices. This stocks also show less
perfect synchrony with market movements, frequent periods in which no meaningful price changes can occur, and occasional outlying price
changes that are promptly reversed. These influences cause some measures of stock prices variability to be biased.
In defining the Variability in Markets index, we standardize the formulas for the three categories relative to one another to provide one index
for the total population.
Variability in Markets Descriptors
A. Optioned Stocks
1. Cumulative Range (+)
2. Beta * Sigma (+)
3. Option Standard Deviation (+)
4. Daily Standard Deviation (+)
B. Listed Stocks
1. Beta *Sigma (+)
3. Daily Standard Deviation (+)
4. Volume to Variance (+)
5. Log of Price (-)
6. Serial Dependence (+)
7. Annual Share Turnover (-)
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Session 09
C. Thin Stocks
1. Beta *Sigma (+)
3. Annual Share Turnover (+)
4. Log of Price (-)
5. Serial Dependence (-)
2. Success (SCS)
The Success index identifies stocks that have been recently successful mainly in terms of stock price but also in terms of earnings. The
relative strength of a stock, shown by the stock price, is the chief indicator of how well the stock has gone. The Success index measures the
success of the company over both the last year and the last five years. It does this in two ways: first, as measured by earnings growth (fiveyear growth in earnings, growth in earnings in the latest year, and present growth in earnings implied by the IBES data); and second, as
measured by price behavior in the market over the last five years and the last year (historical alpha and relative strength). In addition, we use
frequency of dividend cuts as a negative indication.
Success Descriptors
1. Relative Strength (+)
2. Historical Alpha (+)
3. Recent Earnings Change (+)
4. IBES Earnings Growth (+)
5. Dividend Cuts, 5-Year (-)
6. Growth in EPS (+)
24

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Multifactor Models and Valuation

Problems with CAPM and Multifactor Models

Problems with CAPM and the Rise of Multifactor Models

Problem 1: Pricing anomalies (risk or irrationality?)

Size Premium puzzle: Small firms do better than large firms

Mean reversion in long term returns (over-reaction)

Momentum in short term returns (under-reaction)

Accounting-based anomalies (accruals, pension funding, etc.)

Copyright Jos M. Marn

Multifactor Models and Valuation

Problem 2: CAPM-based portfolios are not economically intuitive

Copyright Jos M. Marn

Multifactor Models and Valuation

Motivation: The two factors case

bik : sensitivity of asset is return to factor k

it : security specific (idiosyncratic) portion of the return on asset i

Copyright Jos M. Marn

Multifactor Models and Valuation

The factors capture the common variation in the N assets, so

where denotes the premium associated with factor k.

One Factor Model

Copyright Jos M. Marn

R%it = ai + bi1 F%1t + bi 2 F%2t + %it

Multifactor Models and Valuation

Arbitrage Pricing (I) The Simplest Case

for some slope 1.

Multifactor Models and Valuation

The plot below indicates an arbitrage opportunity.

Multifactor Models and Valuation

but the point for asset 3 lies above that line.

bp1 = 0.5b11 + 0.5b21 = 0.5(0.5 +1.5) = 1.0.

Going long $1 of asset 3 and short $1 of portfolio p provides the payoff

Multifactor Models and Valuation

Rit = Ei + bi1F1t i=1,2,3

o The return of this portfolio is:

o In order for no arbitrage opportunities to exist, portfolio x must also satisfy:

Copyright Jos M. Marn

Multifactor Models and Valuation

E1x1 + E2x2+ E3x3 = 0

R it = ai + bi1 F1t + bi 2 F2t +L+ biK FKt + it

We obtain the pricing formula:

E i = R f + bi11 + bi 2 2 +L+ biK K

Copyright Jos M. Marn

Multifactor Models and Valuation

Multifactor Models and Valuation

o the Fkts may or may not be prespecified

be constant, at least in the short run, or

change as functions of the firms characteristics

o the factors may or may not be prespecified

Copyright Jos M. Marn

Multifactor Models and Valuation

Portfolio Choice: Mimicking Portfolios and Optimal Portfolios

The pricing relation can be written as

which implies ai = 0 in (11).

Multifactor Models and Valuation

An alternative portfolio P composed of

Copyright Jos M. Marn

Multifactor Models and Valuation

Tailoring Risk Exposures

Multifactor Models and Valuation

Copyright Jos M. Marn

Multifactor Models and Valuation

Popular Factor Models