A Protocol for Factor Identification
Forthcoming, Review of Financial Studies
64 Pages Posted: 14 Jul 2018
Date Written: June 16, 2018
We propose a protocol for identifying genuine risk factors. A genuine risk factor must be related to the covariance matrix of returns, must be priced in the cross-section of returns, and should yield a reward-to-risk ratio that is reasonable enough to be consistent with risk pricing. A market factor, a profitability factor, and traded versions of macroeconomic factors pass our protocol, but many characteristic-based factors do not. Several of the underlying characteristics, however, do command premiums in the cross-section.
Keywords: factor, risk factor, risk premium, protocol, select factors
JEL Classification: G00, G11, G12
Suggested Citation: Suggested Citation