Factors that Fit the Time Series and Cross-Section of Stock Returns / Martin Lettau, Markus Pelger.

Format:

Book

Author/Creator:

Lettau, Martin.

Contributor:

National Bureau of Economic Research.

Pelger, Markus.

Series:

Working Paper Series (National Bureau of Economic Research) no. w24858.

NBER working paper series no. w24858

Language:

English

Physical Description:

1 online resource: illustrations (black and white);

Place of Publication:

Cambridge, Mass. National Bureau of Economic Research 2018.

Summary:

We propose a new method for estimating latent asset pricing factors that fit the time-series and cross-section of expected returns. Our estimator generalizes Principal Component Analysis (PCA) by including a penalty on the pricing error in expected returns. We show that our estimator strongly dominates PCA and finds weak factors with high Sharpe-ratios that PCA cannot detect. Studying a large number of characteristic sorted portfolios we find that five latent factors with economic meaning explain well the cross-section and time-series of returns. We show that out-of-sample the maximum Sharpe-ratio of our five factors is more than twice as large as with PCA with significantly smaller pricing errors. Our factors are based on only a subset of the stock characteristics implying that a significant amount of characteristic information is redundant.

Notes:

Print version record

July 2018.