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FRM Part II · FRM Exam Part II · Factors

A portfolio manager compares two approaches to explaining equity returns: the Fama-French model using portfolio-based factors such as SMB and HML, and a macroeconomic factor model using variables such as GDP growth, inflation surprises and changes in credit spreads. Which statement correctly distinguishes them?

Macroeconomic factor models rely on unexpected changes in economic variables, which are generally not tradable, while Fama-French factors are returns on long-short portfolios formed by sorting stocks on characteristics like size and book-to-market. This makes the Fama-French factors tradable and characteristic-based.

  1. AMacroeconomic factor models use only unexpected changes in variables, whereas Fama-French factors are built from long-short portfolios of stocks sorted on characteristicsCorrect
  2. BFama-French factors are macroeconomic surprises, whereas macro models use stock characteristics
  3. CBoth approaches require factors to be non-tradable economic series
  4. DMacroeconomic models require factors to be uncorrelated with each other, whereas Fama-French factors never are

Explanation

Macro factor models typically use surprises (unexpected changes) in economic variables, which are often not directly tradable. Fama-French factors are returns on long-short portfolios sorted by characteristics like size and book-to-market, so they are tradable. The other statements invert or overstate these features.

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