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Answer: Determine factors that account for the covariance in observed returns.
In statistical factor models, historical and cross-sectional return data are analyzed to identify factors that explain the variance or covariance in observed returns. This approach does not require the factors to have an economic or fundamental connection to returns, and data mining may produce spurious factors lacking economic meaning. Therefore, option B is correct as it accurately describes the primary objective of statistical factor models.
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With respect to return-generating models, statistical factor models:
A
Only incorporate factors that possess economic significance.
B
Determine factors that account for the covariance in observed returns.
C
Exclusively include factors with a fundamental linkage to returns.