Factor Models using Machine learning Approach

Why Factor investing is important and why it matters?

  1. Macro-Economic Factors models: GDP
  2. Micro-Economic Factors models: Fundamental Data
  3. Implicit Factor models: statistical artifact

Benefits of Factor Investing?

Factor Models

Ri,t- rf,t =αi+ βi(Rm,t−rf,t) + εi,t — Eq(1)

LOL(use Google image next time)


Decomposition of Risk
  1. Market
  2. Size(small-cap stocks tens to outperform large-cap stocks)
  3. Value( value stocks tend to outperform growth stocks )
  4. Momentum (past winners tends to outperform past losers)
  5. volatility(low volatility stocks tend to outperform high volatility stocks)

Using Factor Models for portfolio construction and analysis

Ri,t- rf,t =αi+ βi(Rm,t−rf,t) + εi,t

Ri,t =rf,t+ βi(Rm,t−rf,t)

Machine Learning Approach(Penalty Methods)

  1. additive and linear (or transformed linear) relationship between the explanatory (independent) variables and the forecast (dependent) variable,
  2. The lack of high dependency between the explanatory variables, and
  3. A causal relationship between the explanatory variables and the forecast variable. The second assumption — the lack of multi-collinearity — is required for the solution of the estimation optimization model. Due to the nature of economic problems, we must be careful to avoid spurious relationships — sometimes called sunspot linkages. A penalized regression model is based on shrinkage assumptions taken from machine learning concepts.

How to select the Optimal Penalty Parameter, The Lambda

Procedure For applying Regularized Regression to Asset allocation

  1. Select the Factors/Features that span the investor’s assets categories
  2. Conduct Regularized Regression over a chosen Historical Time period
  3. Calculate Optimal Tuning Parameter(Lambda)
  4. Compute Factor Loading with Lambda
  5. Apply Risk Allocation For Portfolio Construction




Finance 🤜🤛 Machine Learning Linkedin:https://www.linkedin.com/in/abhishek-chikara-96b68597/

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Abhishek Chikara

Abhishek Chikara

Finance 🤜🤛 Machine Learning Linkedin:https://www.linkedin.com/in/abhishek-chikara-96b68597/

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