1-24. Risk Factor Models

Let’s clean up the formulas a bit. We can move the constant factor exposures outside of the covariance operators. Also, the covariance of a factor with itself is also called the variance of that factor. So, the expressions now look like this. So, to summarize, we can express the pairwise covariance of two stocks as … Read more

Recall that I’m referring to the first stock as butter pecan ice cream. The second stock can be modeled in a similar way. We can think of it as another flavor of ice cream. Like mint chocolate chip. Similar to before, the second stocks variance can be modeled as two parts. The part that is … Read more

If you haven’t looked at variance operators in a while, it may not be obvious why we’re able to take the constant factor exposure out by squaring it. Just a reminder of why we’d square the constant when putting it outside of the variance operator. Remember, that variance takes the square of each observations difference … Read more

Let’s begin with our matrix notation, and consider a portfolio with two stocks, in a model that uses two factors. The variance of the portfolio is the weighted sum of the variances and pairwise covariances of its stocks. We can think of each stock as a different flavor of ice cream, such as butter pecan … Read more

We can also model the portfolio’s variance as a function of factors. The portfolio’s variance can be broken up into two parts, the risk contribution of the factors, and the specific risk that is not due to the factors. Note that is similar to what we saw earlier with the factor model of returns. The … Read more

Already know, let’s add one more layer of complexity, by using a factor model to describe a portfolio of stocks. A portfolio’s return can also be modeled as a sum of two parts, the returns that can be explained by a set of factors, and the returns that are specific to each stock within the … Read more

To get us ready to look at the risk factor model, let’s review the factor model of returns. Note that some of this may look familiar from an earlier lesson, which is great. Our team is really excited about what you’ll be able to do by the time you get to this next project. But … Read more

We’ve previously seen how volatility is a common measure of risk. Variance is just the volatility squared. If we were to estimate the variance of a portfolio of two stocks, we would calculate this as the weighted sum of the variance of the returns of each stock as well as the covariance between the returns … Read more

Coming up, we’ll cover major flavors of the risk model. We’ll start with a risk model that uses a single risk factor, the market return. This is the capital asset pricing model which you’ve learned earlier. Then, we’ll build on this to learn about the Fama French three factor model. The Fama French model which … Read more

Hi there. So far, you’ve been introduced to the concept of a factor and the framework of the multifactor model. We’ve also touched upon how in practice we defined some factors as risk factors and other factors as alpha factors. In this lesson, we will focus on risk factors and the fundamentals of the risk … Read more