NATIONAL BUREAU OF ECONOMIC RESEARCH
NATIONAL BUREAU OF ECONOMIC RESEARCH
loading...

Characteristics Are Covariances: A Unified Model of Risk and Return

Bryan Kelly, Seth Pruitt, Yinan Su

NBER Working Paper No. 24540
Issued in April 2018
NBER Program(s):The Asset Pricing Program

We propose a new modeling approach for the cross section of returns. Our method, Instrumented Principal Components Analysis (IPCA), allows for latent factors and time-varying loadings by introducing observable characteristics that instrument for the unobservable dynamic loadings. If the characteristics/expected return relationship is driven by compensation for exposure to latent risk factors, IPCA will identify the corresponding latent factors. If no such factors exist, IPCA infers that the characteristic effect is compensation without risk and allocates it to an "anomaly" intercept. Studying returns and characteristics at the stock-level, we find that four IPCA factors explain the cross section of average returns significantly more accurately than existing factor models and produce characteristic-associated anomaly intercepts that are small and statistically insignificant. Furthermore, among a large collection of characteristics explored in the literature, only eight are statistically significant in the IPCA specification and are responsible for nearly 100% of the model's accuracy.

download in pdf format
   (529 K)

email paper

Machine-readable bibliographic record - MARC, RIS, BibTeX

Document Object Identifier (DOI): 10.3386/w24540

Published: Bryan T. Kelly & Seth Pruitt & Yinan Su, 2019. "Characteristics Are Covariances: A Unified Model of Risk and Return," Journal of Financial Economics, .

 
Publications
Activities
Meetings
NBER Videos
Themes
Data
People
About

National Bureau of Economic Research, 1050 Massachusetts Ave., Cambridge, MA 02138; 617-868-3900; email: info@nber.org

Contact Us