Abstract and Keywords
The use of equity factor models is increasingly significantly within the institutional asset management community. They are routinely used to estimate the potential benchmark relative returns of equity securities and portfolios. Equity factor models offer numerous advantages over simple historical observation in providing understandable linkages between security characteristics and subsequent returns, and filtering out much of the random noise affecting returns. Most importantly such models help clarify the distinction between return generating processes that impact a particular security, and processes which are in common across many firms. The return models are used to describe whether a particular return generating process is in equilibrium or to reveal an anomaly in asset pricing theory. Random matrix theory has been used to demonstrate that blind factor models often incorrectly identify factors where there is no true underlying structure of the observed returns. A variety of pricing models can be used to value the options, allowing for the inclusion of stochastic processes for volatility and interest rates. Several techniques have become available to make such models respond more rapidly to changes in financial market conditions.
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