A Protocol for Factor Identification

47 Pages Posted: 5 Nov 2014

See all articles by Kuntara Pukthuanthong

Kuntara Pukthuanthong

University of Missouri, Columbia

Richard Roll

California Institute of Technology

Multiple version iconThere are 4 versions of this paper

Date Written: November 1, 2014

Abstract

Several hundred factor candidates have been suggested in the finance literature. We propose a protocol for determining which factor candidates are related to risks and which candidates are related to mean returns. Factor candidates could be related to both risk and returns, to neither, or to one but not the other.

A characteristic such as firm size, or anything else known in advance, cannot be a factor. However, characteristics can be related to mean returns either because they happen to align with factor loadings or because they represent arbitrage opportunities. Pervasive factors with accompanying risk premium should be related to the covariances among returns on assets held in the aggregate market portfolio.

Time variation in both risk premiums and covariances is a challenge, but manageable with recently developed statistical procedures. We illustrate those techniques and also propose a new instrumental variables method to resolve the errors-in-variables problem in estimating factor exposures (betas) for individual assets.

Suggested Citation

Pukthuanthong, Kuntara and Roll, Richard W., A Protocol for Factor Identification (November 1, 2014). Available at SSRN: https://ssrn.com/abstract=2517944 or http://dx.doi.org/10.2139/ssrn.2517944

Kuntara Pukthuanthong (Contact Author)

University of Missouri, Columbia ( email )

Robert J. Trulaske, Sr. College of Business
403 Cornell Hall
Columbia, MO 65211
United States
6198076124 (Phone)

HOME PAGE: http://https://kuntara.weebly.com

Richard W. Roll

California Institute of Technology ( email )

1200 East California Blvd
Mail Code: 228-77
Pasadena, CA 91125
United States
626-395-3890 (Phone)
310-836-3532 (Fax)

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