Asset Pricing Models and Economic Risk Premia: A Decomposition

Abstract

The risk premia of linear factor models on economic (non-traded) risk factors can be decomposed into: i) the premium on maximum-correlation portfolios mimicking the factors; ii) (minus) the covariance between the non-traded components of the pricing kernel and the factors; and iii) (minus) the mispricing of the maximum-correlation portfolios. The first component is independent of a model's non-traded variability and mispricing, and is typically estimated with little bias and high precision. We conclude that the premia on maximum-correlation portfolios are appealing alternatives to the risk premia of linear factor models, with the dividend yield being the only economic factor significantly priced.

Keywords: economic factors, risk premia, pricing kernel, maximum-correlation portfolio

JEL Classification: G12