Using Individual Stocks or Portfolios in Tests of Factor Models
Columbia Business School - Finance and Economics; National Bureau of Economic Research (NBER)
University of California, San Diego (UCSD) - Rady School of Management
University of Pennsylvania - Finance Department
March 14, 2008
AFA 2009 San Francisco Meetings Paper
We examine the asymptotic efficiency of using individual stocks or portfolios as base assets to test cross-sectional asset pricing models. The literature has argued that creating portfolios reduces idiosyncratic volatility and enables factor loadings, and consequently risk premia, to be estimated more precisely. We show analytically and find empirically that the more efficient estimates of betas from creating portfolios do not lead to lower asymptotic variances of factor risk premia estimates. Instead, the standard errors of factor risk premia estimates are determined by the cross-sectional distribution of factor loadings and residual risk. Creating portfolios shrinks the dispersion of betas and leads to higher asymptotic standard errors of risk premia estimates.
Number of Pages in PDF File: 41
Keywords: Specifying Base Assets, Cross-Sectional Regression, Estimating Risk Premia
JEL Classification: G12working papers series
Date posted: March 17, 2008
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