Constructing Factor Mimicking Portfolios
Constructing Factor Mimicking Portfolios
Loading saved threads...
rudinable · External communityPost link
External question — Quantitative Finance Stack Exchange
Author: rudinable
Original post: https://quant.stackexchange.com/questions/83891
License: CC BY-SA 4.0 — https://creativecommons.org/licenses/by-sa/4.0/
Adaptation: HTML converted to plain text; contact email addresses removed.
I'm working with some factor data from a third party company. Their factor model is estimated on a broad universe. I'm trying to re-estimate the model on a smaller subset (my own universe) to construct factor mimicking portfolios. Essentially, I want to find portfolios from within my universe that track their factor most closely.
Let's begin with a factor model:
$r_{i,t} = X_{i, t-1}^{'} F_t + \eta_{i, t}$
with a
$k \times 1$
vector of factor returns
$F_t$
, or in matrix form:
$\mathbf{r}_t = \mathbf{X}_{t-1}F_t+\mathbf{\eta}_t$
. Now let's say I know my betas
$\mathbf{X}_{t-1}$
, and then I estimate factor returns with a weighted least squares scheme:
$\hat{\mathbf{F}}_t = \arg{\min_{\mathbf{F}}} (\mathbf{r}_t - \mathbf{X}_{t-1}\mathbf{F})'\mathbf{W}_t(\mathbf{r}_t - \mathbf{X}_{t-1}\mathbf{F}).$
Then I have the factor mimicking portfolios as
$(\mathbf{X}_{t-1}' \mathbf{W}_t \mathbf{X}_{t-1})^{-1} \mathbf{X}_{t-1}'\mathbf{W}_t.$
The problem that I'm having is that this matrix is ill conditioned, because in the factor model there is exact collinearity. For example, including a country factor along with industry factors (as my model does) leaves two independent variables with the value 1. As a result, an additional constraint is imposed so that industry weights sum to 0 instead of 1. I'm having trouble seeing how this gets incorporated into the solution. How can I find the normalization matrix
$\mathbf{Z}_{t-1}$
which incorporates this additional constraint and fixes the estimation?
I.e. then we have
$\mathbf{Z}_{t-1}(\mathbf{X}_{t-1}' \mathbf{Z}_{t-1}'\mathbf{W}_t \mathbf{Z}_{t-1} \mathbf{X}_{t-1})^{-1} \mathbf{X}_{t-1}' \mathbf{Z}_{t-1}'\mathbf{W}_t$
, i'm just not sure what to use for
$\mathbf{Z}_{t-1}$
. Thanks.
Quote
Report
Viat · External communityPost link
External answer — Quantitative Finance Stack Exchange
Author: Viat
Original post: https://quant.stackexchange.com/a/83910
License: CC BY-SA 4.0 — https://creativecommons.org/licenses/by-sa/4.0/
Adaptation: HTML converted to plain text; contact email addresses removed.
I think this is what you are looking for.
Quote
Report
Post Reply
Checking account access…