Covariances Versus Characteristics in General Equilibrium

Abstract:     
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 are 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 more likely to blame. Most important, the investment approach completes the consumption approach in general equilibrium, especially for cross-sectional asset pricing.

Institutional subscribers to the NBER working paper series, and residents of developing countries may download this paper without additional charge at www.nber.org.

Number of Pages in PDF File: 46

working papers series