Factors (finance)

A factor is a common characteristic among a group of assets. In the equities market, it could be a particular financial ratio such as the price–earnings (P/E) or the  book–price (B/P) ratios. Additional objectives are:


 * Factors frequently are intended to capture some economic intuition. For example, a factor may help understand the prices of assets by reference to their exposure to sources of macroeconomic risk, fundamental characteristics, or basic market behaviour.
 * Assets with similar factors (characteristics) tend to behave in similar ways. This attribute is critical to the success of a factor.
 * The factor should be able to differentiate across different markets and samples.
 * The factor should be robust across different time periods.

Factors fall into three categories—macroeconomic influences, cross-sectional characteristics, and statistical factors.


 * Macroeconomic influences are time series that measure observable economic activity. Examples include interest rate levels, gross domestic production, and industrial production.
 * Cross-sectional characteristics are observable asset specifics or firm characteristics. Examples include, dividend yield, book value, and volatility.
 * Statistical factors are very different in nature than the above factors as they do not have direct economic interpretation.

Factors are variables used to create a linear model (equation) which describes the returns of a portfolio. In the CAPM model, a portfolio's returns can be described reasonably well based on its exposure to one factor: Beta.

In their three-factor model, Fama and French expand on the CAPM model by adding two factors, HmL and SmB, that fits actual portfolio returns more closely.