In the capital mrkts expectations section, is anybody understanding the way the CFAI txtbook calculates covariance using multifactor models? What a mess. Why multifactor model “filter” out noise and simplify task of estimating covariance? Thanks in advance
Conceptually, when you introduce structure (such as a factor model) the number of parameters that you need to estimate goes down. That reduces impact of noise (spurious correlations) and simplifies covariance estimation. for example, if you have n assets, without factor models you would have to estimate n*(n+1)/2 parameters. With one factor model, you would need to estimate n + n + 1 = 2n+1 (n betas, n residuals and market variance). Does that help?
Oh yeah perfect, I understand now. For the exam, are you studying the formula for the 2-factor covariance? Thanks
mik, I’m already done with the CFA exams. You might have to check out LOS to see what’s required. Good luck!