Factor Model

Quant Trading Strategies & Ideas
1

Course Name: Quantitative Portfolio Management, Section No: 13, Unit No: 12, Unit type: Notebook



I am a bit confused. A factor model should help me decide how to allocate assets, the CAPM and Fama French Models are one form of the factor model. What is happening here is that we are developing a momentum strategy and using it as a factor. Is this right? Why? My first intuition was that you were building a portfolio composed of two strategies, the first is momentum and the other mean reverting and through the factor model with all the different factors included (economic, size, quality, etc.) can help us decide how much weight to allocate to each strategy.



Why didn't we use the same approach we used in Fama French model, but instead of putting SMB, we put an economic indicator or other style factors. Is there an another way to quantify the momentum factor using the same approach?  

2

Hi Jad,



The momentum is being used as a factor itself! You can read more about the ongoing research and findings regarding the same by looking up 'momentum factor'.

Additionally, you may refer to these resources:

  1. Quantpedia article
  2. Factor Research article



    You can definitely work with macroeconomic factors or use fundamental analysis to make composite factors. The real-world implementation would ideally be a combination of momentum factor plus some fundamental factor/economic indicator.



    Hope this helps!
3

Thank you Gaurav Singh for your prompt response.



So basically, we designed a momentum factor from scratch. This factor is usually referred to as UMD defined by Carhart. That being said, we can now create a momentum strategy and test its exposure to the UMD Carhart factor. 



I find below an example of a factor model: 



E[Ri] - E[Rf] = alpha + B1(MarketRiskPremium) + B2(SMB) + B3(HML) + B4(UMD) + error



https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2543802



Did I get it right?



 

4

Hey Jad,



The 4-factor model is one of the ways where momentum can be used as a factor. You got the equation right and can also refer to more information here if you want!



Hope this helps!

Thanks!

5

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This query has already been answered here.