Three Types of Factor Models
1. Macroeconomic factor model
(a) Factors are observable economic and financial time series
2. Fundamental factor model
(a) Factors are created from observerable asset characteristics
3. Statistical factor model
(a) Factors are unobservable and extracted from asset returns
Factor Model Specification
The three types of multifactor models for asset returns have the general form
R
it
= α
i
+ β
1i
f
1t
+ β
2i
f
2t
+ ···+ β
Ki
f
Kt
+ ε
it
(1)
= α
i
+ β
0
i
f
t
+ ε
it
• R
it
is the simple return (real or in excess of the risk-free rate) on asset i
(i =1,...,N) in time period t (t =1,...,T),
• f
kt
is the k
th
common factor (k =1,...,K),
• β
ki
is the factor loading or factor beta for asset i on the k
th
factor,
• ε
it
is the asset specificfactor.
