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The Cross-Section of Risk and Return

50 Pages Posted: 6 Dec 2017  

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; Columbia Business School - Finance and Economics

Tano Santos

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

Multiple version iconThere are 2 versions of this paper

Date Written: December 5, 2017

Abstract

In the finance literature, a common practice is to create factor-portfolios by sorting on characteristics (such as book-to-market, profitability or investment) associated with average returns. The goal of this exercise is to create a parsimonious set of factor-portfolios that explain the cross-section of average returns, in the sense that the returns of these factor-portfolios span the mean-variance efficient portfolio. We argue that this is unlikely to be the case, as factor-portfolios constructed in this way fail to incorporate information about the covariance structure of returns. By using a high statistical power methodology to forecast future covariances, we are able to construct a set of portfolios which maintains the expected return, but hedges out much of the unpriced risk. We apply our methodology to hedge out unpriced risk in the Fama and French (2015) five-factors. We find that the squared Sharpe ratio of the optimal combination of the resulting hedged factor-portfolios is 2.29, compared with 1.31 for the unhedged portfolios, and is highly statistically significant.

Keywords: Factor Models, 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 (December 5, 2017). 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
United States
212-854-4679 (Phone)
212-854-4679 (Fax)

HOME PAGE: http://www.columbia.edu/~kd2371/

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

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

Columbia Business School - Finance and Economics ( email )

3022 Broadway
New York, NY 10027
United States

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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