Factor model relationships are built on the following critical assumptions EXCEPT
A) the random error term and factor are serially correlated in time-series approaches
B) the outcome of the factor has not bearing on the outcome of the random error term
C) the random error terms of any two securities are uncorrelated
D) the outcome of the random error term of one security has no bearing on the outcome of the random error term of the other

Question

Quizplus · Accepted Answer

The critical assumptions of factor models include that the outcome of the factor has no bearing on the outcome of the random error term, the random error terms of any two securities are uncorrelated, and the outcome of the random error term of one security has no bearing on the outcome of the other. However, serial correlation of the random error term and factor in time-series approaches is not an assumption but rather a potential issue that needs to be addressed.

Factor Model Relationships Are Built on the Following Critical Assumptions