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Modern Portfolio TheoryThe Factor Models and The Arbitrage Pricing Theory Chapter 8 By Ding zhaoyong Return-generating Processand Factor Models Return-generating process Is a statistical model that describe how return on a security is produced. The task of identifying the Markowitz efficient set can be greatly simplified by introducing this process. The market model is a kind of this process, and there are many others. Return-generating Processand Factor Models Factor models These models assume that the return on a security is sensitive to the move-ments of various factors or indices. In attempting to accurately estimate expected returns, variances, and covariances for securities, multiple-factor models are potentially more useful than the market model. Return-generating Processand Factor Models Implicit in the construction of a factor model is the assumption that the returns on two securities will be correlated only through common reactions to one or more of the specified in the model. Any aspect of a security’s return unexplained by the factor model is uncorrelated with the unique elements of returns on other securities. Return-generating Processand Factor Models A factor model is a powerful tool for portfolio management. It can supply the information needed to calculate expected returns, variances, and covariances for every security, which are the necessary conditions for determining the curved Markowitz efficient set. It can also be used to characterize a portfolio’s sensitivity to movement in the factors. Return-generating Processand Factor Models Factor models supply the necessary level of abstraction in calculating covariances. The problem of calculating covariances among securities rises exponentially as the number of securities analyzed increase. Practically, abstraction is an essential step in identifying the Markowitz set. Return-generating Processand Factor Models Factor models provide investment managers with a framework to identify important f
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