How to build a linear factor model
Algorithmic trading strategies use factor models to quantify the relationship between the return of an asset and the sources of risk that are the main drivers of these returns. Each factor risk carries a premium, and the total asset return can be expected to correspond to a weighted average of these risk premia.
There are several practical applications of factor models across the portfolio management process, from construction and asset selection to risk management and performance evaluation. The importance of factor models continues to grow as common risk factors are now tradeable:
- A summary of the returns of many assets, by a much smaller number of factors, reduces the amount of data required to estimate the covariance matrix when optimizing a portfolio.
- An estimate of the exposure of an asset or a portfolio to these factors allows for the management of the resulting risk, for instance, by entering suitable hedges when risk...
