Covariances, Characteristics, and General Equilibrium: A Critique
Charles A. Dice Center Working Paper No. 2011-15
41 Pages Posted: 22 Jul 2011 Last revised: 27 Feb 2012
Date Written: December 1, 2011
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: Suggested Citation