Multi-Factor Models

Multi-Factor Models Explained

1

A multi-factor model is used in the analysis of securities when constructing an investment portfolio. It is used to assess the link between two or more variables and the return of a stock/portfolio.

2

For example, a multi-factor model could explain how a stock reacts to different interest rates and currency prices. If interest rates increase by 0.1%, the model may calculate that a stock will decrease by 0.5%.

3

When constructing a multi-factor model, it can be difficult to know what variables to include and how many. The data used in the model is also usually historic, which means that it cannot predict the future.  

4

Nonetheless, multi-factor models are useful in terms of giving you an understanding of how a stock reacts in relation to other variables. The most famous models are CAPM and the three-factor model.

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