What is Factor Models?
Factor models are basically mathematical models which are developed to approximate the returns of financial security or a transaction through running various statistical techniques over a bunch of factors which are believed to affect the return being approximated and therefore the models are so-called because the outcome depends on the factors included in the same.
These factors can be of varying nature such as government rules and regulations, seasonality, market environment and so on and each of the factors is assigned an appropriate weight on the basis of how much is that factor affecting the return or the dependent variable.
There can be various types of models depending upon the depth of the analysis and therefore they are broadly classified into two heads, which are single and multi-factor models. We can use simpler statistics or complicated ones, regression is a popular method used.
Types of Factor Model
As described above, there can be two broad heads of these models, Single Factor Models, and Multi-Factor Models. The equations of each are as follows:
1. Single Factor Model
- This model involves using only one independent variable to approximate the dependent variable and has an equation of the following form:
- y = α + β1X1 +∈1
- Here y is the dependent variable, = the intercept variable, = the slope variable, = the independent variable or the factor, = error term
- CAPM equation is an example of the single factor model wherein the equation is as follows:
- E(r) = Rf + β1(Rm – Rf)
- Here we approximate the expected return on the basis of risk-free return and the market risk premium while beta is the slope coefficient and risk-free return is the intercept coefficient.
- Intercept coefficient implies the value of the dependent variable when the factor value = 0
- The slope coefficient determines the rate of change in the dependent variable to a rate of change in the independent variable.
2. Multiple Factor Model
- This model involves using multiple independent variables to approximate the dependent variable and has an equation of the following form:
- y = α + β1X1 + β1X1 + ⋅⋅⋅ + βnXn + ∈
- Here y is the dependent variable, = the intercept variable, all variables are the slope coefficients for different independent variables
- Fama Fench equation is an example of the multi-factor model wherein the equation is as follows:
- E(r) = Rf + β1 (Rm – Rf) + β2(SMB) + β1(HML)
- HML = Value Premium
- SMB = Size Premium
Uses and Importance
- There are many different models that are used in the Finance industry presently while new models can be developed for a specific industry or any other purpose.
- These are not just used in Finance, they have multi-disciplinary applications, they can be used in science, economics, sociology, anthropology, and so on
- Many indices have developed their own factor models which are used to predict their returns and are therefore used by investors also in making investing decisions
- These models are also used in identifying the most appropriate capital structure for a company because the WACC formula is also a version of a multi-factor model that considers the costs and weights of capital sources and therefore helps in calculating the cost of capital for different capital structures.
- Such models are used in performance attribution of portfolios, wherein the analyst identifies the causes of a given return and thus the skill and performance of the portfolio manager are also quantified, based on which her remuneration number is generated.
Advantages and Disadvantages of Factor Models
Below are the points that explain the advantages and disadvantages for the same:
- Factor models help in pinpointing the cause of the change in the dependent variables and identify the factors which are causing the same. Once the cause and effect relationship is clearly defined, it is easier to harness and predict such impacts in a structured manner.
- Investing can be made scientific and higher returns can be achieved using the models with high predictive power and therefore algorithms can be generated for automated trading. However, such automation is only used when the stakes are not very high because this limits the losses which might be very huge otherwise.
- Businesses can develop marketing and expansion strategies based on factor models of their domain and thereby develop a plan to achieve higher profits and then closely monitor the results. This helps them in aligning the goals and objectives of the company as a whole.
- Identifying the right factors is not an easy task and there are many cautions that need to be taken into consideration to draw a valid conclusion out of a given model. If the data set is affected by multicollinearity or serial correlations and other violation of regression assumptions, then the model can become unstable and not have any consistent predictive power.
- Factor models are not highly cost-effective. They require the use of sophisticated statistical techniques which in turn require expensive technology and therefore cannot be used by smaller companies or retail investors who don’t possess the required resources.
- These models require highly skilled human capital because these require advanced mathematical acumen and therefore the people involved in such research come at a high cost.
- At times adding more factors might not explain the effect on the dependent variable and therefore the model might reach a particular limit and that might not be too extensive to justify the time, money, and effort that goes into such analysis.
So to sum up, Factor models help in predicting the change in the dependent variable to the change in a set of independent variables known as factors. There can be single and multi-factor models as per the need and resources available to the research and therefore they can have a varying degree of predictive power.
Even though these models are very popular, they are not free from cons, their implementation is expensive, and therefore not all investors or businesses can use them, plus they require highly skilled human capital, which is not always available. Even so, as the world is becoming more technology-driven, modeling is becoming an inherent and indispensable part of how businesses are conducted.
This is a guide to Factor Models. Here we discuss what is Factor Models, the types with their equation, explanation, importance and advantages and disadvantages. You can also go through our other related articles to learn more –