Robert j mckeown u of t eco358 week six topic 4

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Robert J. McKeown (U of T) ECO358 Week Six
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Topic 4: Multifactor APT and CAPM Example Robert J. McKeown (U of T) ECO358 Week Six
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Topic 5: Where to look for factors? Topic 5: Where to look for factors? Robert J. McKeown (U of T) ECO358 Week Six
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Topic 5: Where to look for factors? Factors What to include as independent (exogenous) variables to predict returns and measure premia? For simplicity, we want as few factors as possible. Robert J. McKeown (U of T) ECO358 Week Six
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Topic 5: Where to look for factors? Macro-Factor Models Chen, Roll, and Ross Five-Factor Model includes: 1 industrial output, 2 expected inflation, 3 unanticipated inflation, 4 excess return of corporate bond over long-term government bonds, and 5 excess return of long-term gov’t bonds over short-term gov’t bills. Robert J. McKeown (U of T) ECO358 Week Six
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Topic 5: Where to look for factors? Firm Characteristics Models Fama and French (FF) Three-Factor Model 1 Market Index – S&P500, or TSX Composite, etc. 2 Small Minus Big – the return of a portfolio of small stocks in excess of the return on big stocks. 3 High Minus Low – the return of a portfolio of high book-to-value 1 stocks less a portfolio of low book-to-value stocks. 1 Value refers to market value. Robert J. McKeown (U of T) ECO358 Week Six
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Topic 5: Where to look for factors? Debate on APT and the FF Model Why do these factors a ect asset returns? Two possibilities 1 The rational possibility: these factors are correlated with a “true” but not yet discovered fundamental factor that generates asset returns. 2 The irrational possibility: these factors reflect behavioural biases 2 and/or market frictions. 2 A bias represents a consistent over-estimate or under-estimate. Biases can be broken into two broad categories, cognitive and emotional. Robert J. McKeown (U of T) ECO358 Week Six
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Topic 5: Where to look for factors? Additional factors Momentum – a large amount of alpha in many mutual funds can be attributed to it. High (low) returns persist for many months. The FF with momentum is the Four-Factor Model. Robert J. McKeown (U of T) ECO358 Week Six
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