Covariances, Characteristics, and General Equilibrium: A Critique

Fisher College of Business Working Paper No. 2011-03-015

Charles A. Dice Center Working Paper No. 2011-15

41 Pages Posted: 22 Jul 2011 Last revised: 27 Feb 2012

See all articles by Xiaoji Lin

Xiaoji Lin

University of Minnesota

Lu Zhang, 张橹

Ohio State University - Fisher College of Business; National Bureau of Economic Research (NBER)

Multiple version iconThere are 2 versions of this paper

Date Written: December 1, 2011

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 can be 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 likely to blame. Most important, the investment approach completes the consumption approach in general equilibrium, especially for cross-sectional asset pricing.

Keywords: covariances, characteristics, general equilibrium, asset pricing anomalies, capital markets research in accounting, market efficiency, investment-based asset pricing

JEL Classification: D21, D92, E22, E44, G12, G14, G31, G32, G35

Suggested Citation

Lin, Xiaoji and Zhang, Lu, Covariances, Characteristics, and General Equilibrium: A Critique (December 1, 2011). Fisher College of Business Working Paper No. 2011-03-015; Charles A. Dice Center Working Paper No. 2011-15. Available at SSRN: https://ssrn.com/abstract=1890886 or http://dx.doi.org/10.2139/ssrn.1890886

Xiaoji Lin

University of Minnesota ( email )

420 Delaware St. SE
Minneapolis, MN 55455
United States

Lu Zhang (Contact Author)

Ohio State University - Fisher College of Business ( email )

2100 Neil Avenue
Columbus, OH 43210-1144
United States
585-267-6250 (Phone)

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

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