The Cross-Section of Risk and Return

68 Pages Posted: 6 Dec 2017 Last revised: 6 Nov 2019

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 University - Columbia Business School, Finance

Simon Rottke

University of Amsterdam - Finance Group

Tano Santos

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

Multiple version iconThere are 2 versions of this paper

Date Written: November 04, 2019

Abstract

In the finance literature, a common practice is to create characteristic 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 develop a procedure to remove this unpriced risk using covariance information estimated from past returns. We apply our methodology to the five Fama and French (2015) characteristic portfolios. The squared Sharpe ratio of the optimal combination of the resulting characteristic efficient portfolios is 2.16, compared with 1.16 for the original characteristic 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 (November 04, 2019). Columbia Business School Research Paper No. 18-4, 2019. 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
United States
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 University - Columbia Business School, Finance ( email )

NY
United States
10027 (Fax)

HOME PAGE: http://sites.google.com/view/liramota

Simon Rottke (Contact Author)

University of Amsterdam - Finance Group ( email )

Roetersstraat 18
Amsterdam, 1018 WB
Netherlands

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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