Interpreting Factor Models

47 Pages Posted: 5 Apr 2017 Last revised: 29 Dec 2017

Serhiy Kozak

University of Michigan, Stephen M. Ross School of Business

Stefan Nagel

University of Chicago - Booth School of Business; National Bureau of Economic Research (NBER); Centre for Economic Policy Research

Shrihari Santosh

University of Maryland - R.H. Smith School of Business

Date Written: March 27, 2017

Abstract

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

Kozak, Serhiy and Nagel, Stefan and Santosh, Shrihari, Interpreting Factor Models (March 27, 2017). Journal of Finance, Forthcoming. Available at SSRN: https://ssrn.com/abstract=2945654

Serhiy Kozak (Contact Author)

University of Michigan, Stephen M. Ross School of Business ( email )

701 Tappan Street
Ann Arbor, MI MI 48109
United States

Stefan Nagel

University of Chicago - Booth School of Business ( email )

5807 S. Woodlawn Avenue
Chicago, IL 60637
United States

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Centre for Economic Policy Research ( email )

77 Bastwick Street
London, EC1V 3PZ
United Kingdom

Shrihari Santosh

University of Maryland - R.H. Smith School of Business ( email )

Robert H. Smith School of Business
Van Munching Hall
College Park, MD 20742
United States

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