NATIONAL BUREAU OF ECONOMIC RESEARCH
NATIONAL BUREAU OF ECONOMIC RESEARCH
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Yinan Su

Johns Hopkins University
Carey Business School
100 International Drive
Baltimore Maryland 21202
Baltimore, MD 21202

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Institutional Affiliation: Johns Hopkins University

NBER Working Papers and Publications

April 2018Characteristics Are Covariances: A Unified Model of Risk and Return
with Bryan Kelly, Seth Pruitt: w24540
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 charac...

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

 
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