When Do Cross-Sectional Asset Pricing Factors Span the Stochastic Discount Factor? / Serhiy Kozak, Stefan Nagel.

Format:

Book

Author/Creator:

Kozak, Serhiy.

Contributor:

National Bureau of Economic Research.

Nagel, Stefan.

Series:

Working Paper Series (National Bureau of Economic Research) no. w31275.

NBER working paper series no. w31275

Language:

English

Physical Description:

1 online resource: illustrations (black and white);

Place of Publication:

Cambridge, Mass. National Bureau of Economic Research 2023.

Summary:

When expected returns are linear in asset characteristics, the stochastic discount factor (SDF) that prices individual stocks can be represented as a factor model with GLS cross-sectional regression slope factors. Factors constructed heuristically by aggregating individual stocks into characteristics-based factor portfolios using sorting, characteristics-weighting, or OLS cross-sectional regression slopes do not span this SDF unless the covariance matrix of stock returns has a specific structure. These conditions are more likely satisfied when researchers use large numbers of characteristics simultaneously. Methods to hedge unpriced components of heuristic factor returns allow partial relaxation of these conditions. We also show the conditions that must hold for dimension reduction to a number of factors smaller than the number of characteristics to be possible without having to invert a large covariance matrix. Under these conditions, instrumented and projected principal components analysis methods can be implemented as simple PCA on characteristics-based portfolios.

Notes:

Print version record

May 2023.