Asset Pricing Models and Economic Risk Premia: A Decomposition
43 Pages Posted: 6 Mar 2008 Last revised: 10 Sep 2009
Date Written: September 8, 2009
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. For a given set of assets available for investment, the first component is the same across models 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
Suggested Citation: Suggested Citation