LO 62.1: Provide examples of factors that impact asset prices, and explain the

LO 62.1: Provide examples of factors that impact asset prices, and explain the theory of factor risk premiums.
In the context of factor investing, it is easiest to think of assets as bundles of factor risks, where exposure to the different factor risks earns risk premiums. The underlying factors may include the market (which is a tradable investment factor), interest rates, or investing styles (including value/growth, low volatility, or momentum). Factors may also be classified as fundamental macroeconomic factors, such as inflation and economic growth.
Factor theory is based on an analysis of factor risks. Factor risks represent exposures to bad times, where these exposures are rewarded with risk premiums. Factor theory is based on three primary principles: 1. Factors are important, not assets. It is not exposure to the specific asset that matters, rather the exposure to the underlying risk factors. As a result, investors must look through assets and understand the underlying factor risks.
2. Assets represent bundles o f factors. Assets typically represent bundles of risk factors,
although some assets, like equities and government bonds, can be thought of as factors themselves. Other assets, including corporate bonds, private equity, and hedge funds, contain many factors, such as equity risk, interest rate risk, volatility risk, and default risk. Assets risk premiums reflect these risk factors.
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Topic 62 Cross Reference to GARP Assigned Reading – Ang, Chapter 6
Investors have differing optimal risk exposures. Investors each have different optimal exposures to risk factors. One of the important factors is volatility. Higher volatility results in higher asset risks during bad times. One important recent example of bad times was the 20072009 financial crisis. In return for bearing factor risks, investors require compensation through a risk premium (e.g., a volatility premium for volatility risk) during normal times. Economic growth represents another factor to which investors want different exposures.
Bad times could represent economic bad times, including high inflation and low economic growth. They could also represent bad times for investing, including poorly performing investments or markets. Factors are all unique and each represents exposure to a different set of bad times.
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