Linear Factor Models and the Estimation of Expected Returns

53 Pages Posted: 20 Apr 2016 Last revised: 6 Feb 2024

See all articles by Cisil Sarisoy

Cisil Sarisoy

Board of Governors of the Federal Reserve System

Peter de Goeij

Tilburg University

Bas J. M. Werker

Tilburg University - Center for Economic Research (CentER)

Multiple version iconThere are 2 versions of this paper

Date Written: January 20, 2024

Abstract

This paper analyzes the properties of expected return estimators on individual assets/portfolios implied by the linear factor models of asset pricing, i.e., the product of factor exposures and prices of risk. We provide the asymptotic properties of factor-model-based expected return estimators, which yield the standard errors for risk premium estimators for individual assets/portfolios. We show that using factor-model-based risk premium estimates leads to sizable precision gains compared to using historical averages. Finally, inference about expected returns does not suffer from a small-beta bias when factors are traded. The more precise factor-model-based estimates of expected returns translate into sizable improvements in out-of-sample performance of optimal portfolios.

Keywords: Cross Section of Expected Returns, Risk Premium, Small Betas.

JEL Classification: C13, C38, G11

Suggested Citation

Sarisoy, Cisil and de Goeij, Peter and Werker, Bas J.M., Linear Factor Models and the Estimation of Expected Returns (January 20, 2024). Netspar Discussion Paper No. 03/2016-020, Available at SSRN: https://ssrn.com/abstract=2766515 or http://dx.doi.org/10.2139/ssrn.2766515

Cisil Sarisoy (Contact Author)

Board of Governors of the Federal Reserve System ( email )

20th Street and Constitution Avenue NW
Washington, DC 20551
United States

Peter De Goeij

Tilburg University ( email )

P.O. Box 90153
Room I607
Tilburg, Noord-Brabant 5000 LE
Netherlands
+31134662083 (Phone)

Bas J.M. Werker

Tilburg University - Center for Economic Research (CentER) ( email )

Econometrics and Finance Group
5000 LE Tilburg
Netherlands

Do you have negative results from your research you’d like to share?

Paper statistics

Downloads
260
Abstract Views
1,736
Rank
205,131
PlumX Metrics