1. Asset classes are usually well-defined, stable, and directly investable
2. Factors represent exposure to risk and, in general, are not directly investable
3. Types of factors
- observable economic/financial time series (macroeconomic factors);
- created from observable asset characteristics (fundamental factors);
- not observable and extracted from asset returns (statistical or latent factors).\
4. Factors appear to have strong diversification properties because they often have low correlations with each other and sometimes even negative correlations with one another. On the other hand, asset classes usually exhibit strong positive correlations.
5. Factor based Returns
- the factors need to be stationary and their unconditional moments are given by
- the error terms are uncorrelated with each one of the common factors, i.e.,
- Finally, the error terms are serially uncorrelated, but contemporaneously correlated across assets, that is
6. Factor models can be examined through 3 lenses
1. time series regressions
2. cross-section regressions
3. multivariate regressions
6. Factor models can be examined through 3 lenses