Factor model

Factor model, a financial model which helps in constructing portfolios by employing multiple factors. When constructing a factor-based portfolio, factors should be chosen wisely. On comparing these factors, one can explain the returns and risk of the securities in a portfolio.  

Returns from a factor model can be calculated as:

Here, 

is the relative market risk.

Rp is the return of the portfolio.

Ri is the risk-free rate.

Rm is the average expected rate of return on the market.

Example: Assume for an asset ‘ABC’,
=0.80

Ri=3%

Rm=9%

Rp=0.03 +0.80(0.09-0.03)

Rp=0.078

7.8% is the rate of return to invest in ‘ABC’ asset.