Shrinking the Cross Section / Serhiy Kozak, Stefan Nagel, Shrihari Santosh.

Format:

Book

Author/Creator:

Kozak, Serhiy.

Contributor:

National Bureau of Economic Research.

Nagel, Stefan.

Santosh, Shrihari.

Series:

Working Paper Series (National Bureau of Economic Research) no. w24070.

NBER working paper series no. w24070

Language:

English

Physical Description:

1 online resource: illustrations (black and white);

Place of Publication:

Cambridge, Mass. National Bureau of Economic Research 2017.

Summary:

We construct a robust stochastic discount factor (SDF) that summarizes the joint explanatory power of a large number of cross-sectional stock return predictors. Our method achieves robust out-of-sample performance in this high-dimensional setting by imposing an economically motivated prior on SDF coefficients that shrinks the contributions of low-variance principal components of the candidate factors. While empirical asset pricing research has focused on SDFs with a small number of characteristics-based factors--e.g., the four- or five-factor models discussed in the recent literature--we find that such a characteristics-sparse SDF cannot adequately summarize the cross-section of expected stock returns. However, a relatively small number of principal components of the universe of potential characteristics-based factors can approximate the SDF quite well.

Notes:

Print version record

November 2017.