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 a job opening that you would like to promote on SSRN?

Paper statistics

Downloads
263
Abstract Views
1,759
Rank
186,785
PlumX Metrics