7. Understanding, applying, and critiquing different factor models

Single and multi-factor asset pricing models are tools investors can use to select securities and build portfolios. These models fall at the intersection of the efficient frontier and investor objectives since asset prices ultimately reflect asset-specific features (timing, amount, and variability of future cash flows) and investor preferences. In another way, investors have risk preferences and return objectives and are faced with making tradeoffs between these subject to the available risk-return features offered by the universe of assets. Ultimately, an investor's portfolio choice can be modeled according to modern portfolio theory as a mean-variance optimization problem where an investor seeks to maximize expected utility subject to an individual level of risk aversion. Expected utility is frequently modeled as a function of the expected value of an asset's excess return (the return over and above the risk-free rate or risk premium) offset by a penalty for an investor's risk aversion.