Article2021

Asset Pricing with Omitted Factors

358 citations0/0 files storedJournal of Political Economy

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Financial Markets and Investment Strategies Stochastic processes and financial applications Financial Risk and Volatility Modeling

Abstract

Standard estimators of risk premia in linear asset pricing models are biased if some priced factors are omitted. We propose a three-pass method to estimate the risk premium of an observable factor, which is valid even when not all factors in the model are specified or observed. The risk premium of the observable factor can be identified regardless of the rotation of the other control factors if together they span the true factor space. Our approach uses principal components of test asset returns to recover the factor space and additional regressions to obtain the risk premium of the observed factor.

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References

1973Risk, Return, and Equilibrium: Empirical Tests 1976The arbitrage theory of capital asset pricing 2003Liquidity Risk and Expected Stock Returns 2006The Cross‐Section of Volatility and Expected Returns 2002Determining the Number of Factors in Approximate Factor Models 1972Capital Market Equilibrium with Restricted Borrowing 2005What Explains the Stock Market's Reaction to Federal Reserve Policy?2015… and the Cross-Section of Expected Returns

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