NATIONAL BUREAU OF ECONOMIC RESEARCH
NATIONAL BUREAU OF ECONOMIC RESEARCH
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Shrinking the Cross Section

Serhiy Kozak, Stefan Nagel, Shrihari Santosh

NBER Working Paper No. 24070
Issued in November 2017
NBER Program(s):Asset Pricing

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.

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Document Object Identifier (DOI): 10.3386/w24070

Published: Serhiy Kozak & Stefan Nagel & Shrihari Santosh, 2019. "Shrinking the Cross-Section," Journal of Financial Economics, .

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