Risk Price Variation: The Missing Half of the Cross-Section of Expected Returns

60 Pages Posted: 21 Jun 2018 Last revised: 16 Sep 2018

See all articles by Andrew J. Patton

Andrew J. Patton

Duke University - Department of Economics

Brian Weller

Duke University - Department of Economics

Date Written: September 14, 2018

Abstract

The Law of One Price is a bedrock of asset pricing theory and empirics. Yet real-world frictions can violate the Law by generating unequal compensation across assets for the same risk exposures. We develop new methods for cross-sectional asset pricing with unobserved heterogeneity in compensation for risk. We extend k-means clustering to group assets by risk prices and introduce a formal test for whether differences in risk premia across market segments are too large to occur by chance. Using portfolios of US stocks, international stocks, and assets from multiple classes, we find significant evidence of cross-sectional variation in risk prices for all 135 combinations of test assets, factor models, and time periods. Variation in risk prices is as important as variation in risk exposures for explaining the cross-section of expected returns.

Keywords: Risk Premia, Market Segmentation, Clustering, Expectation Maximization

JEL Classification: G12, G14, C21, C55

Suggested Citation

Patton, Andrew J. and Weller, Brian, Risk Price Variation: The Missing Half of the Cross-Section of Expected Returns (September 14, 2018). Economic Research Initiatives at Duke (ERID) Working Paper No. 274. Available at SSRN: https://ssrn.com/abstract=3192846 or http://dx.doi.org/10.2139/ssrn.3192846

Andrew J. Patton

Duke University - Department of Economics ( email )

213 Social Sciences Building
Box 90097
Durham, NC 27708-0204
United States

HOME PAGE: http://econ.duke.edu/~ap172/

Brian Weller (Contact Author)

Duke University - Department of Economics ( email )

Durham, NC
United States

HOME PAGE: http://sites.google.com/site/brianmweller/

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