Asset-Pricing Models and Economic Risk Premia: A Decomposition

Abstract:     
The risk premia assigned to economic (non-traded) risk factors can be decomposed into three parts: i) the risk premia on maximum-correlation portfolios mimicking the factors; ii) (minus) the covariance between the non-traded components of the candidate pricing kernel of a given model and the factors; and iii) (minus) the mis-pricing assigned by the candidate pricing kernel to the maximum-correlation mimicking portfolios. The first component is the same across asset-pricing models, and is typically estimated with little (absolute) bias and high precision. The second component, on the other hand, is essentially arbitrary, and can be estimated with large (absolute) biases and low precisions by multi-beta models with non-traded factors. This second component is also sensitive to the criterion minimized in estimation. The third component is estimated reasonably well, both for models with traded and non-traded factors. We conclude that the economic risk premia assigned by multi-beta models with non-traded factors can be very unreliable. Conversely, the risk premia on maximum-correlation portfolios provide more reliable indications of whether a non-traded risk factor is priced. These results hold for both the constant and the time-varying components of the factor risk premia.

Number of Pages in PDF File: 55

Keywords: economic risk premia, non-traded factors, maximum-correlation portfolios

JEL Classification: G12

working papers series