1-23. Factor Models and Types of Factors

Another descriptive attributes of common risk factors, is that they are well known by the investment community. This is not just a descriptive attribute, it also affects how risk factors drive price movements. When most of the investors in the market understand how a factor drives the price movement of a stock, then it’s unlikely … Read more

We generally observe different attributes among risk factors versus alpha factors. Even though factors fall along a graded incremental spectrum of these attributes, it helps to put them into two groups to get a sense of how risk factors and alpha factors differ. One difference is in the magnitude of the factors contribution to the … Read more

In the coming series of lessons, we’ll go into detail about risk factors and alpha factors. So, what’s the difference, and why do we make this distinction? First, let’s start with how factors, whether risk factors or alpha factors, are the same. The use of factors this is based on the assumption that stocks with … Read more

Okay. So, we’ve learned a little about factor models. So, how are they used in practice? It might not be what you expect. Most practitioners don’t use factor models to explicitly model asset returns. Factor modeling has a long history in academic research, and some of these methods were used in the past to explicitly … Read more

Okay. We talked about the assumptions inherent to factor models. Now, let’s derive the covariance matrix of the returns, in terms of the factor returns, exposures, and residual term. We need this description of the return variants, because we want to be able to use our factor model to describe and manage the portfolio variance, … Read more

There are a couple of assumptions inherent to strict factor models. The first is that the residual return is assumed to be uncorrelated with each of the factor returns. This does not restrict the set of possible models as much as it may seem. The factor exposures can be adjusted to achieve the condition where … Read more

We left off with the idea that the return of any stock, i, can be decomposed into the returns of factors times the stocks exposures to those factors plus an unexplained portion. But wait, this is looking a lot like multiple regression. What’s the difference? Well, regression is one tool you might use to build … Read more

Hey, you made it. You’ve learned quite a lot in this lesson, from the principles of factor models to the covariance matrix of factor returns, to the application of factor models and quant finance. Yes. Congrats on building up your understanding of factors. You’ve also learned about the distinction between alpha factors and risk factors … Read more

Alternative data could be generated by scraping social media profiles of companies, tracking building permits or hospital purchases, and analyzing satellite imagery to name a few examples. Construction companies file permit requests with local governments when installing components of a house and also when upgrading components. This information could be tracked to better understand the … Read more

Advanced natural language processing techniques are being used to enhance fundamental analysis. Fundamental analysis is the kind of work done by traditional investment analysts who work for financial institutions, like mutual funds and brokerage firms. Much of the text-based analysis that fundamental researchers perform on companies, whether it’s reading financial news, reading quarterly earnings reports, … Read more

If you are starting out in the field of finance and you ask any experienced portfolio manager, investment banker or research analyst for advice on how to improve your skills, it’s very likely that one of their suggestions would be to read financial news. Most people working in financial services read financial and business news … Read more

In the history of finance, there has been a continued search to find new sources of information and to derive meaning from them. For instance, before the 1980s, stock traders used to get their financial data from newspapers. However, stock exchanges began to use computers to automate their record keeping and Bloomberg terminals were invented … Read more

Analysts factors are derived from the published reports of sell-side research analysts at investment banks. Their reports include ratings such as buy, hold, or sell. They also include earnings estimates or price targets for the stock. Sell-side analysts may be assigned to a few companies within the same industry, and may even meet with the … Read more

Okay. So, we’ve talked about factors in the abstract and in your head you’re thinking, “Okay, it’s a vector where the values for each stock are proportional to some aspect of the future performance of that stock.” Yes, you’re right. When I first learned this, in some ways, it wasn’t very satisfying to me. But … Read more

Event driven strategies are often combined with fundamental and sentiment factors which help us interpret the significance of the event. For example, companies typically will release their earnings once every three months. The dates are scheduled in advance so there are opportunities to make trading decisions both before and after the event. For pre-event trading, … Read more

Index adds can drive buying of the stock that was added to a major index, while index deletions can drive selling of that stock. So, why is that? You’ll recall, that an index is not a fund. So, what causes this buying and selling when an index changes? Recall that funds and ETFs, particularly passive … Read more

The previous factors that we’ve seen, such as price and volume, book-to-market, and analyst forecasts, tend to occur at regular intervals, whether it’s daily or quarterly. Another class of factors are based on events that may not be scheduled and may have a significant impact on the stock price. For example, when the Deepwater Horizon … Read more

Many fundamental factors are different variations of the price to earnings ratio. Note that [inaudible] typically use the data measured as earnings per share divided by price instead of price divided by earnings. Why? Earnings could be zero or close to zero. So, the data using price divided by earnings may end up with numbers … Read more

The other commonly used data in factor construction are called fundamentals. These are measures derived from financial statements such as price to earnings ratios. Price volume factors and fundamental factors are the most commonly used factors for quant trading, and it’s possible for some active fund managers to rely primarily on these two types of … Read more

Volume-based factors usually include price information, to categorize the volume in a given time period as a net buy or net sell. At first glance, the idea of net buying or net selling, may appear counterintuitive when you recall, that every transaction involves a buyer and a seller. Some examples will help to clarify what … Read more