NATIONAL BUREAU OF ECONOMIC RESEARCH
NATIONAL BUREAU OF ECONOMIC RESEARCH

Covariances versus Characteristics in General Equilibrium

Xiaoji Lin, Lu Zhang

NBER Working Paper No. 17285
Issued in August 2011
NBER Program(s):   AP   CF

We question a deep-ingrained doctrine in asset pricing: If an empirical characteristic-return relation is consistent with investor "rationality," the relation must be "explained" by a risk factor model. The investment approach changes the big picture of asset pricing. Factors formed on characteristics are not necessarily risk factors: Characteristics-based factor models are linear approximations of firm-level investment returns. The evidence that characteristics dominate covariances in horse races does not necessarily mean mispricing: Measurement errors in covariances are more likely to blame. Most important, the investment approach completes the consumption approach in general equilibrium, especially for cross-sectional asset pricing.

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Document Object Identifier (DOI): 10.3386/w17285

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