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FRM Part II · FRM Exam Part II · Factor Theory

Which approach to defining the value factor is most consistent with standard practice in factor investing?

The value factor is conventionally built by buying stocks with high book-to-market (cheap) ratios and shorting those with low book-to-market (expensive) ratios, as in the Fama-French HML factor. Sorting on past returns, capitalisation or volatility defines momentum, size and low-volatility factors instead.

  1. AGoing long stocks with high book-to-market ratios and short stocks with low book-to-market ratiosCorrect
  2. BGoing long stocks with high past returns and short stocks with low past returns
  3. CGoing long stocks with low market capitalisation and short stocks with high capitalisation
  4. DGoing long stocks with low return volatility and short stocks with high volatility

Explanation

Value is typically proxied by valuation ratios such as book-to-market, earnings yield or cash flow yield, buying cheap and shorting expensive stocks (HML in Fama-French). The other options describe momentum, size and low volatility respectively.

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