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Assignment
In this assignment, students will construct factor mimicking portfolios of economic
variables for portfolio management and hedging purpose. The structure of this assignment is
as follows: Section 1 introduce the idea of economic variables in a multifactor asset pricing
model, Section 2 discusses how to retrieve signals from given economic time series, Section
3 discusses a method for constructing factor mimicking portfolios, and assignment questions
are given in Section 4.
1. Economic variables
The multifactor structure under ICAPM and APT provides a strong empirical
improvement over CAPM. A multifactor model is usually given by
where " denotes the asset return at time , (," denotes the -th factor return at time , and" is the error term. However, both theories are vague in defining specific factors to be
included in the multifactor model1.
A common way to find suitable factors is to look at the discounted cash flow (DCF)
model. Under the DCF model, the present value of the asset may be calculated as
1 In fact, ICAPM of Merton (1973) did provide some rules for selecting factors—the market return and variables
that proxy for the changes of investment opportunity set.