Covariances Versus Characteristics in General Equilibrium

46 Pages Posted: 12 Aug 2011

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)

Date Written: August 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 are 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 more likely to blame. Most important, the investment approach completes the consumption approach in general equilibrium, especially for cross-sectional asset pricing.

Suggested Citation

Lin, Xiaoji and Zhang, Lu, Covariances Versus Characteristics in General Equilibrium (August 2011). NBER Working Paper No. w17285. Available at SSRN: https://ssrn.com/abstract=1908573

Xiaoji Lin (Contact Author)

University of Minnesota ( email )

420 Delaware St. SE
Minneapolis, MN 55455
United States

Lu Zhang

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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