Question: When constructing fundamental/technical/analyst factors to be used in a factor model, the approach advocated in lectures is to use a specially constructed long-short portfolio to

  1. When constructing fundamental/technical/analyst factors to be used in a factor model, the approach advocated in lectures is to use a specially constructed long-short portfolio to represent the factor. Explain in detail how these factor replicating portfolios are constructed and why each step is taken. [8]
  2. Will the approach you discussed in part (A) create the appropriate factor replicating portfolio if there is a high degree of correlation between factors that describe asset returns? Explain why/why not. [5]

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