Inference on Risk Premia in the Presence of Omitted Factors

76 Pages Posted: 19 Jun 2017

See all articles by Stefano Giglio

Stefano Giglio

Yale School of Management; National Bureau of Economic Research (NBER); Centre for Economic Policy Research (CEPR)

Dacheng Xiu

University of Chicago - Booth School of Business

Multiple version iconThere are 2 versions of this paper

Date Written: June 2017

Abstract

We propose a three-pass method to estimate the risk premia of observable factors in a linear asset pricing model, which is valid even when the observed factors are just a subset of the true factors that drive asset prices or they are measured with error. We show that the risk premium of a factor can be identified in a linear factor model regardless of the rotation of the other control factors as long as they together span the space of true factors. Motivated by this rotation invariance result, our approach uses principal components to recover the factor space and combines the estimated principal components with each observed factor to obtain a consistent estimate of its risk premium. Our methodology also accounts for potential measurement error in the observed factors and detects when such factors are spurious or even useless. The methodology exploits the blessings of dimensionality, and we therefore apply it to a large panel of equity portfolios to estimate risk premia for several workhorse linear models. The estimates are robust to the choice of test portfolios within equities as well as across many asset classes.

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Suggested Citation

Giglio, Stefano and Xiu, Dacheng, Inference on Risk Premia in the Presence of Omitted Factors (June 2017). NBER Working Paper No. w23527. Available at SSRN: https://ssrn.com/abstract=2988748

Stefano Giglio (Contact Author)

Yale School of Management ( email )

135 Prospect Street
P.O. Box 208200
New Haven, CT 06520-8200
United States

National Bureau of Economic Research (NBER) ( email )

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Centre for Economic Policy Research (CEPR) ( email )

London
United Kingdom

Dacheng Xiu

University of Chicago - Booth School of Business ( email )

5807 S. Woodlawn Avenue
Chicago, IL 60637
United States

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