Efficient Estimation of a Semiparametric Characteristic-Based Factor Model of Security Returns

63 Pages Posted: 21 Sep 2007

See all articles by Gregory Connor

Gregory Connor

London School of Economics & Political Science (LSE) - Department of Accounting and Finance

Matthias Hagmann-von Arx

University of Lausanne - Institute of Banking & Finance (IBF)

Oliver B. Linton

University of Cambridge

Multiple version iconThere are 2 versions of this paper

Date Written: September 17, 2007

Abstract

This paper develops a new estimation procedure for characteristic-based factor models of security returns. We treat the factor model as a weighted additive nonparametric regression model, with the factor returns serving as time-varying weights, and a set of univariate nonparametric functions relating security characteristic to the associated factor betas. We use a time-series and cross-sectional pooled weighted additive nonparametric regression methodology to simultaneously estimate the factor returns and characteristic-beta functions. By avoiding the curse of dimensionality our methodology allows for a larger number of factors than existing semiparametric methods. We apply the technique to the three-factor Fama-French model, Carhart's four-factor extension of it adding a momentum factor, and a five-factor extension adding an own-volatility factor. We find that momentum and own-volatility factors are at least as important if not more important than size and value in explaining equity return comovements.

We test the multifactor beta pricing theory against the Capital Asset Pricing model using a standard test, and against a general alternative using a new nonparametric test.

Keywords: Additive Models, Arbitrage pricing theory, Factor model, Fama-French, Kernel estimation, Nonparametric regression, Panel data

JEL Classification: G12, C14

Suggested Citation

Connor, Gregory and Hagmann-von Arx, Matthias and Linton, Oliver B., Efficient Estimation of a Semiparametric Characteristic-Based Factor Model of Security Returns (September 17, 2007). Swiss Finance Institute Research Paper No. 07-26, Available at SSRN: https://ssrn.com/abstract=1016025 or http://dx.doi.org/10.2139/ssrn.1016025

Gregory Connor (Contact Author)

London School of Economics & Political Science (LSE) - Department of Accounting and Finance ( email )

Houghton Street
London WC2A 2AE
United Kingdom
+44 702 955-6407 (Phone)
+44 702 955-7420 (Fax)

Matthias Hagmann-von Arx

University of Lausanne - Institute of Banking & Finance (IBF) ( email )

CH-1015 Lausanne
Switzerland

Oliver B. Linton

University of Cambridge ( email )

Faculty of Economics
Cambridge, CB3 9DD
United Kingdom

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