Characteristics and the Cross-Section of Covariances

61 Pages Posted: 22 Mar 2018 Last revised: 10 Feb 2020

See all articles by Charles Clarke

Charles Clarke

University of Kentucky - Finance

Matthew Linn

Isenberg School of Management, University of Massachusetts

Date Written: March 16, 2018

Abstract

We propose a new, minimally parameterized way of modeling stock-level covariances as a function of firm characteristics. Our model uses a large number of indicator functions to approximate the surface mapping two firms' characteristics to the correlation of their returns. We show that the method performs better than existing methods both in and out of our sample period. In truly out of sample tests, we show that using the information in firm characteristics, we can predict future covariances better than when using common asset pricing models. Correspondingly, we discuss how one can use our model as an avenue for understanding how characteristics relate to stock returns in the context of linear asset pricing models.

Keywords: Empricial Asset Pricing, Cross-Section of Stocks, Covariance Estimation, Portfolio Optimization

JEL Classification: G11, G12

Suggested Citation

Clarke, Charles and Linn, Matthew, Characteristics and the Cross-Section of Covariances (March 16, 2018). Available at SSRN: https://ssrn.com/abstract=3141622 or http://dx.doi.org/10.2139/ssrn.3141622

Charles Clarke (Contact Author)

University of Kentucky - Finance ( email )

Gatton School of Business and Economics
Department of Finance and Quantitative Methods
Lexington, KY 40506
United States
214-886-7675 (Phone)

HOME PAGE: http://https://sites.google.com/site/charlievclarke/

Matthew Linn

Isenberg School of Management, University of Massachusetts ( email )

Amherst, MA 01003
United States

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