Arbitrage Pricing Theory and Multi-Factor Models › Multi-Factor Models in Practice

APT provides a theoretical foundation but leaves the factors unspecified. In practice, researchers and practitioners have developed two main approaches to identifying factors: macroeconomic factor models and fundamental factor models.

Macroeconomic models use observable economic variables as factors. This approach is intuitive: since factors represent systematic risks that affect many assets, they should correspond to economy-wide variables that influence corporate profits, discount rates, and investor behavior.

Chen, Roll, and Ross (1986) proposed a five-factor model using:

1. Industrial production growth: Captures the state of the real economy
2. Changes in expected inflation: Affects discount rates and corporate profits differently
3. Unexpected inflation: Transfers wealth between borrowers and lenders
4. Credit spread changes: The difference between corporate and government bond yields, capturing default risk perceptions
5. Term structure changes: Shifts in the yield curve slope, affecting the relative pricing of different maturities

Each of these variables has clear economic content. Industrial production growth measures the real output of the economy, and stocks of companies with greater exposure to economic cycles should be more sensitive to this factor. Unexpected inflation redistributes wealth between debtors and creditors, benefiting firms with fixed-rate debt while harming those with fixed-rate assets. Credit spread changes signal shifts in the perceived riskiness of corporate debt, which naturally affects equity values as well.

Macroeconomic factors offer clear economic interpretations, but data lags and revisions make real-time implementation challenging.

Fundamental factor models use characteristics of securities themselves to explain returns. Rather than specifying macroeconomic variables, these models identify factors based on firm attributes that have historically explained return differences.

This approach differs from macroeconomic models by asking which characteristics have predicted returns historically rather than specifying which economic variables should affect returns. This empirical focus reveals patterns not obvious from economic reasoning.

The most influential fundamental factor model is the Fama-French framework, which we examine in detail next.