The two main types of risk factors included in the famous Barra model are called the "fundamental factors", and "industry factors," and the thing that I do not understand is why are only the former standardized in the factor model?

On pg. 28 of Carol Alexander's very readable Practical Financial Econometrics, it says

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What implicit market assumptions are being upheld by standardizing the risk factors like this? My two main questions are:

  1. I previously thought regression variables were only standardized for the algorithm's sake, and not out of economic justifications. Indeed, this answer suggests that all the risk factors in the model should be standardized.

  2. What if the factors are not standardized, as this link (on pg. 26) implies that they sometimes are?

I have not been able to find any sources on this matter, and would greatly appreciate someone explaining the rationale behind standardizing.


1 Answer 1


Hi: If you don't standardize, then each coefficient will have a different meaning. For example, suppose you have a company, ZZZ, that has a 1.5 standard deviation value of "growth" factor exposure and a 2.5 standard deviation value of "liquidity" factor exposure. Then, if the model coefficient for growth is $\beta_{growth}$ and the model coefficient for liquidity is $\beta_{liquidity}$, then the return ( I forget if it's the company's return or it's excess return ) attribution due to ZZZ's growth factor exposure is $1.5 \times \beta_{growth}$ and the return attribution due to its liquidity factor exposure is $2.5 \times \beta_{liquid}$.


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