The Cross-Section of Risk and Return

52 Pages Posted: 6 Dec 2017 Last revised: 1 Nov 2018

See all articles by Kent D. Daniel

Kent D. Daniel

Columbia Business School - Finance and Economics; National Bureau of Economic Research (NBER)

Lira Mota

Columbia Business School - Finance and Economics

Simon Rottke

University of Muenster - Finance Center Muenster

Tano Santos

Columbia Business School; National Bureau of Economic Research (NBER)

Multiple version iconThere are 2 versions of this paper

Date Written: October 31, 2018

Abstract

In the fi nance literature, a common practice is to create factor-portfolios by sorting on characteristics associated with average returns. We show that the resulting portfolios are likely to capture not only the priced risk associated with the characteristic, but also unpriced risk. We show that the unpriced risk can be hedged out of these factor-portfolios using covariance information estimated from past returns. We apply our methodology to hedge out unpriced risk in the Fama and French (2015) fi ve factor-portfolios. We find that the squared Sharpe-ratio of the optimal combination of the resulting hedged factor-portfolios is 2.26, compared with 1.21 for the unhedged portfolios.

Keywords: Factor Models, Unpriced Risk, Characteristics, Covariances

JEL Classification: G12, G1

Suggested Citation

Daniel, Kent D. and Mota, Lira and Rottke, Simon and Santos, Tano, The Cross-Section of Risk and Return (October 31, 2018). Columbia Business School Research Paper No. 18-4. Available at SSRN: https://ssrn.com/abstract=3083143 or http://dx.doi.org/10.2139/ssrn.3083143

Kent D. Daniel

Columbia Business School - Finance and Economics ( email )

3022 Broadway
New York, NY 10027
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212-854-4679 (Phone)
212-854-4679 (Fax)

HOME PAGE: http://kentdaniel.net/

National Bureau of Economic Research (NBER)

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Cambridge, MA 02138
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Lira Mota

Columbia Business School - Finance and Economics ( email )

3022 Broadway
New York, NY 10027
United States

Simon Rottke (Contact Author)

University of Muenster - Finance Center Muenster ( email )

Universitatsstr. 14-16
Muenster, 48143
Germany

Tano Santos

Columbia Business School ( email )

3022 Broadway - Uris Hall
Room 815
New York, NY 10027
United States
212-854-0489 (Phone)
212-316-9180 (Fax)

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

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