Interpreting Factor Models
47 Pages Posted: 5 Apr 2017 Last revised: 29 Dec 2017
Date Written: March 27, 2017
We argue that tests of reduced-form factor models and horse races between "characteristics" and "covariances'" cannot discriminate between alternative models of investor beliefs. Since asset returns have substantial commonality, absence of near-arbitrage opportunities implies that the SDF can be represented as a function of a few dominant sources of return variation. As long as some arbitrageurs are present, this conclusion applies even in an economy in which all cross-sectional variation in expected returns is caused by sentiment. Sentiment investor demand results in substantial mispricing only if arbitrageurs are exposed to factor risk when taking the other side of these trades.
Keywords: Factor Models, Characteristics, Covariances, Rational, Behavioral
JEL Classification: G12, G14
Suggested Citation: Suggested Citation