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The Impact of Network Connectivity on Factor Exposures, Asset Pricing and Portfolio Diversification

63 Pages Posted: 13 Feb 2017  

Monica Billio

Ca Foscari University of Venice - Dipartimento di Economia

Massimiliano Caporin

University of Padua - Department of Statistical Sciences

Roberto Calogero Panzica

Goethe University Frankfurt - Research Center SAFE

Loriana Pelizzon

Goethe University Frankfurt - Faculty of Economics and Business Administration; Goethe University Frankfurt - Research Center SAFE; Ca Foscari University of Venice

Date Written: December 1, 2016

Abstract

This paper extends the classic factor-based asset pricing model by including network linkages in linear factor models. We assume that the network linkages are exogenously provided. This extension of the model allows a better understanding of the causes of systematic risk and shows that (i) network exposures act as an inflating factor for systematic exposure to common factors and (ii) the power of diversification is reduced by the presence of network connections. Moreover, we show that in the presence of network links a misspecified traditional linear factor model presents residuals that are correlated and heteroskedastic. We support our claims with an extensive simulation experiment.

Keywords: CAPM, volatility, network, interconnections, systematic risk

JEL Classification: G10, G12, F35, C58

Suggested Citation

Billio, Monica and Caporin, Massimiliano and Panzica, Roberto Calogero and Pelizzon, Loriana, The Impact of Network Connectivity on Factor Exposures, Asset Pricing and Portfolio Diversification (December 1, 2016). SAFE Working Paper No. 166. Available at SSRN: https://ssrn.com/abstract=2914218

Monica Billio

Ca Foscari University of Venice - Dipartimento di Economia ( email )

Cannaregio 873
Venice, 30121
Italy

HOME PAGE: http://www.unive.it/persone/billio

Massimiliano Caporin

University of Padua - Department of Statistical Sciences ( email )

Via Battisti, 241
Padova, 35121
Italy

Roberto Calogero Panzica

Goethe University Frankfurt - Research Center SAFE ( email )

(http://www.safe-frankfurt.de)
Theodor-W.-Adorno-Platz 3
Frankfurt am Main, 60323
Germany

Loriana Pelizzon (Contact Author)

Goethe University Frankfurt - Faculty of Economics and Business Administration ( email )

Theodor-W.-Adorno-Platz 3
Frankfurt am Main, D-60323
Germany

Goethe University Frankfurt - Research Center SAFE ( email )

Theodor-W.-Adorno-Platz 3
Frankfurt am Main, 60323
Germany

HOME PAGE: http://www.safe-frankfurt.de

Ca Foscari University of Venice ( email )

Dorsoduro 3246
Venice, Veneto 30123
Italy

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