St.

Mary’s University
School Of Graduate studies
ARBITRAGE PRICING THEORY-BASED GAUSSIAN
TEMPORAL FACTOR ANALYSIS FOR ADAPTIVE
PORTFOLIO MANAGEMENT

Article review

 Abdisa Wondimu yadeta

 ID: SGS/0439/2013A 
 MBA-AF2013_B

Addis Ababa, Ethiopia

December, 2020

Part I General information

Article Title:
Arbitrage pricing theory-based Gaussian temporal factor analysis for adaptive
portfolio management

Author(s):

The article was written by two researchers. Those are Kai-Chun Chiu received
his BBA (Hon.) in accountancy from the Chinese University of Hong Kong in
2000. He is a member of Beta Gamma Sigma. He is currently a PhD student of
the Department of Computer Science and Engineering, the Chinese University
of Hong Kong, Second person who participated in this work was Lei Xu is a
chair professor in the Department of Computer Science and Engineering of the
Chinese University of Hong Kong. He has been concurrently a full professor at
Peking University since 1992, and guest professor at three other universities in
China and the United Kingdom.

Publication: https://www.sciencedirect.com

Publication Information: Decision Support Systems 37 (2004) 485 – 500

Reviewer: Abdisa Wondimu Yadeta

Part II Summary of the article

The study mainly focus on Arbitrage pricing theory (APT) based Gaussian TFA model
for adaptive portfolio management. They refers the Adaptive portfolio management;
study of the traditional Markowitz’s portfolio theory in the framework of artificial
neural networks and the researcher also tried to see the Sharp ratio adaptive portfolio
management via maximizing.

The researchers used in their study identify three typical statistical techniques such
as; principal component analysis (PCA), independent component analysis (ICA) and
maximum likelihood factor analysis for expected returns of securities is linearly
related to k hidden economic factors. These conventional technique would make
compromise on rotation indeterminacy.
Consequently the researcher investigated the technique temporal factor analysis (TFA)
for portfolio optimization. Besides the authors were also extend the approach to some
other variants tailored for investors according to their risk and return objectives.

Researchers were gathered data from stock and index data of Hong Kong. And targeted
three major stock index sources, those are Hang Seng Index (HSI), Hang Seng China-
Affiliated Corporations Index (HSCCI) and Hang Seng China Enterprises Index
(HSCEI).

The Auteurs briefly appraisal on their study about the Arbitrage price theory (APT) and
the Gaussian temporal factory analysis (TFA) and provides an algorithm for
implementing the Arbitrage price theory (APT) based Gaussian temporal factory
analysis (ATP) learning for adaptive portfolio management and also side to side
comparing with the other approaches.

Part III

Analysis and Synthesis: 

The authors of this study has put it an important conclusion which are using TFA for portfolio
management would allow portfolio weights to be indirectly controlled by several hidden factors.
Moreover, the approach is extended to tailor for investors according to their risk and return
objectives.

From my perspective, I appreciate the paper considering that the hidden factors that may affect
the investor’s portfolio returns. The model identified by in the literature would support the
investors to understand and to determine the accurate security returns and hence, enable the
investors to choose the portfolio that meet their risk bearing level. If the Conventional factor
analytic model used, this model would compromise on rotational indeterminacy. Additionally in
the literature many researchers realized that variance was not appropriate for quantifying risk in
the Sharpe ratio because it counted positive returns as risks. Therefore, the recently proposed a
new technique called Temporal Factor Analysis (TFA) would aim to provide an alternative way
for implementing the classical financial APT model for adaptive portfolio management.
Using this new proposed model will reach on accurate results and provide information which
entity has higher risk should have been reported higher risk and vice versa. This will create
investor’s confidence in their investment decision.

We have seen a lot of most important point in the advanced financial management class in
relation to risk return and asset pricing model topic. This topic detailed how to determine
expected returns and associated risk in a single investment and portfolio management. In order to
determine the expected value of investment and its potential risk, the analyst would use the past
historical financial data. This financial data included the past years financial returns only. This
will enables investor to assess the expected future returns and risks for those targeted entities or
industries. Although this will provide a good indicator, it only based on the single factor that is a
past actual return whereas it is likely to expect many more factors which contribute to the output
of investments.

In the articles, the researchers proposed new model which is called Temporal Factor Analysis to
provide alternative ways for implementing the classical APT model to adopt portfolio
management. Using TFA model would benefit removing rotation indeterminacy and allows
portfolio weights to be indirectly controlled by several hidden factors. These several hidden
factors represented by measurement noise in order to consider other factor in the proposed
Temporal Factor Analysis model. This areas of studies isn’t covered yet in the class lecture.

The researchers presented four experimental results and, in Tables 3– 6 shows that the APT-
based portfolio in general performs better than the return-based portfolio if the scope of
comparison is limited to within each scenario and also they compare the performance of APT-
based portfolios across all the four scenarios, especially the portfolio Sharpe ratio of scenario III
against I (z19.50%) and scenario IV against II (z10.58%), and according their final conclusions
the performance may be further improved whenever short sale is permitted. Also indicated on
their study that in Figures 7 and 8, shows that not only is the expected return under control, but
also is risk lowered. As a result, Sp remains more or less constant. And their observation agrees
with the tenet in finance that risk and return go hand in hand with each other.

Part IV Hypothesis Comparison:

The researchers review different statistical techniques such as principal component analysis
(PCA), independent component analysis (ICA) and maximum likelihood factor analysis which
have been used in the different studies. Using them for estimating the hidden factors would
compromise on the terms of zero noise. For this initiation they investigate the new proposed
technique temporal factor analysis for portfolio optimization.

Based on requirement to identify the hypothesis comparison and/or using theoretical framework,
I tried to search for those one in the article. However, the nature of article seems different
conventional research nature. This articles more focus on the financial management theories
rather than research on the financial management. Therefore, the article didn’t demonstrate the
hypothesis comparison or theoretical framework.

Part V understand finance better

In the article the researchers used past bank interest rate, stock and index data of Hong Kong.
Particularly daily closing prices of the one week bank average interest rate 3 major stock indices
as well as 86 actively trading stocks covering the period from January 1, 1998 to December 31,
1999 are used in the model of arbitrage pricing model supported by temporal factor analysis for
adoption of portfolio management.

In our country context, the proposed model may be applicable to bank invest because of the past
financial data on bank interest rate in Ethiopian banking industry can be found easily on their
annual report and National Bank of Ethiopia the governor of Ethiopian financial sectors. Using
the model Ethiopian investors can identify the suitable investment of banks.

There is some concerns in Ethiopia regarding stock and index data as those researchers in the
article used stock and index data of Hong Kong no such kind data sources available. This creates
difficulties in order to invest in non-financial sectors in our country. Applying this model for
Ethiopia would be meaningless as its cost of application would exceed the benefit obtained from
those information.

The article demonstrates several new areas about APT based on TFA, algorithm and advanced
statistical techniques used and simulation areas that I didn’t address till yet. Frankly speaking,
this areas of knowledge appears to be new in our environment. Nonetheless the conventional
method and proposed one will highlight us as there is an advanced ways of management
potential risks and maximization of expected financial returns.

Therefore, the articles will enable us to be ready for future managements of stock indexes data in
our country as Ethiopia has planning establishment of Stock exchange.