Risk factor (finance)

In finance, risk factors are the building blocks of investing, that help explain the systematic returns in equity market, and the possibility of losing money in investments or business adventures.^[1][2] A risk factor is a concept in finance theory such as the capital asset pricing model, 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.^[3]

Risk factors occur whenever any sort of asset is involved, and there are many forms of risks from credit, liquidity risks to investment and currency risks.

Different participants of risk factors contain different risk factors for each participant, for example, financial risks for the individual, financial risks for the Market, financial risks for the Government etc.^[2]