Least Squares Estimation (LSE) and Kalman Filtering (KF) for Factor Modeling:A Geometrical Perspective.

Summary This chapter introduces, illustrates and derives both least squares estimation (LSE) and Kalman filter (KF) estimation of the alpha and betas of a return, for a given number of factors that have already been selected. It formalizes the “per return factor model” and the concept of recursive estimate of the alpha and betas. The chapter explains the setup, objective, criterion, interpretation, and derivations of LSE. The setup, main properties, objective, interpretation, practice, and geometrical derivation of KF are also discussed. The chapter also explains the working of LSE and KF. Numerous simulation results are displayed and commented throughout the chapter to illustrate the behaviors, performance and limitations of LSE and KF.