Linear Factor Models and the Estimation of Expected Returns

58 Pages Posted: 20 Apr 2016 Last revised: 24 May 2021

See all articles by Cisil Sarisoy

Cisil Sarisoy

Board of Governors of the Federal Reserve System

Peter de Goeij

Tilburg University

Bas J. M. Werker

Tilburg University - Center for Economic Research (CentER)

Date Written: May 24, 2021

Abstract


This paper analyzes the properties of expected return estimators on individual assets implied by the linear factor models of asset pricing, i.e., the product of factor exposures and prices of risk. We provide the asymptotic properties of factor-model-based expected return estimators, which yield the standard errors for individual assets. We show that using factor-model-based risk premium estimates leads to sizable precision gains compared to the historical averages. In the presence of omitted factors, adding an alpha to the model captures mispricing only in case of traded factors, otherwise the bias caused by misspecification cannot be corrected. Finally, inference about expected returns, unlike inference on factor prices, does not suffer from a small-beta bias. The more precise factor-model-based estimates of expected returns translate into sizable improvements in out-of- sample performance of optimal portfolios.

Keywords: Cross Section of Expected Returns, Risk Premium, Small Betas, Omitted Factors.

JEL Classification: C13, C38, G11

Suggested Citation

Sarisoy, Cisil and de Goeij, Peter and Werker, Bas J.M., Linear Factor Models and the Estimation of Expected Returns (May 24, 2021). Netspar Discussion Paper No. 03/2016-020, Available at SSRN: https://ssrn.com/abstract=2766515 or http://dx.doi.org/10.2139/ssrn.2766515

Cisil Sarisoy (Contact Author)

Board of Governors of the Federal Reserve System ( email )

20th Street and Constitution Avenue NW
Washington, DC 20551
United States

Peter De Goeij

Tilburg University ( email )

P.O. Box 90153
Room I607
Tilburg, Noord-Brabant 5000 LE
Netherlands
+31134662083 (Phone)

Bas J.M. Werker

Tilburg University - Center for Economic Research (CentER) ( email )

Econometrics and Finance Group
5000 LE Tilburg
Netherlands

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