Covariances, Characteristics, and General Equilibrium: A Critique
Ohio State University (OSU) - Fisher College of Business
Ohio State University - Fisher College of Business; National Bureau of Economic Research (NBER)
December 1, 2011
Fisher College of Business Working Paper No. 2011-03-015
Charles A. Dice Center Working Paper No. 2011-15
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 can be 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 likely to blame. Most important, the investment approach completes the consumption approach in general equilibrium, especially for cross-sectional asset pricing.
Number of Pages in PDF File: 41
Keywords: covariances, characteristics, general equilibrium, asset pricing anomalies, capital markets research in accounting, market efficiency, investment-based asset pricing
JEL Classification: D21, D92, E22, E44, G12, G14, G31, G32, G35working papers series
Date posted: July 22, 2011 ; Last revised: February 27, 2012
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