How to Construct Fundamental Risk Factors?

Without losing in significance power, in beta consistency or in factor efficiency compared to the Fama and French factors, our technique insulates the effects of other sources of risk as much as possible when evaluating one risk factor. Consequently, the approach is neater and leads to risk premiums that may not necessarily be used jointly in a regression-based model, unlike the original Fama and French factors whose risk exposures are highly sensitive to the inclusion of the other factors in the regression. This property is very useful for stepwise factor selection procedures. Besides, the methodology developed in this paper is easily extendable to price risk fundamentals other than the empirical size, book-to-market and momentum effects and to other markets (even to small exchange markets as the technique requires less in terms of data histories). Concluding, this paper creates a theoretical framework for pricing the returns attached to a unit exposure to any particular source of risk.