Risk factor (finance)

A risk factor is a concept in finance theory such as the CAPM, arbitrage pricing theory and other theories that use pricing kernels. In these models, the rate of return of an asset (hence the converse its price) is a random variable whose realization in any time period is a linear combination of other random variables plus a disturbance term or white noise. In practice, a linear combination of observed factors included in a linear asset pricing model (for example, the Fama–French three-factor model) proxy for a linear combination of unobserved risk factors if financial market efficiency is assumed. In the Intertemporal CAPM, non-market factors proxy for changes in the investment opportunity set.^[1]

References

1. Cochrane, John H. (2005). Asset Pricing (Revised Edition). Princeton University Press. ISBN 9781400829132.