Please can someone help me understand why the answer is B. For instance we are at the end of the month, we would ideally have both factor score of current month and return of this month. Why shouldn’t it be A?
The purpose of back-testing is to identify correlations between the current period’s factor scores, FS(t), and the next period’s holding period strategy returns, SR(t+1) so that you could use the calculated coefficient to estimate the next month return based on the data of current month.
The point is that you want to estimate the next month return but you only have the current month factor score that’s why you need to calculate the coefficient by back-testing.
Gotcha. Thank you! So simply put we are trying to predict next months returns with current month’s factor, right?
Yup.
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