Linear Factor Models: Theory, Applications and Pitfalls
51 Pages Posted: 21 Nov 2014 Last revised: 8 Dec 2014
Date Written: Decermber 7, 2014
We clarify the rationale and differences between the two main categories of linear factor models, namely dominant-residual and systematic-idiosyncratic. We discuss the five different, yet interconnected areas of quantitative finance where linear factor models play an essential role: multivariate estimation theory, asset pricing theory, systematic strategies, portfolio optimization, and risk attribution. We present a comprehensive list of common pitfalls and misunderstandings on linear factor models. An appendix details all the calculations. Supporting code is available for download.
Keywords: generalized r-square, fundamental factor models, macroeconomic factor models, factor analysis, regression, random matrix theory, GICS industry classification, cross-sectional models, time-series models, statistical models
JEL Classification: C1, G11
Suggested Citation: Suggested Citation