Review of Financial Studies, vol. 34 No 6, 2813-2856
95 Pages Posted: 31 Oct 2018 Last revised: 24 May 2021
Date Written: August 6, 2020
We propose a new methodology for forming arbitrage portfolios that utilizes the information contained in firm characteristics for both abnormal returns and factor loadings. The methodology gives maximal weight to risk-based interpretations of characteristics' predictive power before any attribution is made to abnormal returns. We apply the methodology to simulated economies and to a large panel of U.S. stock returns. The methodology works well in our simulation and when applied to stocks. Empirically, we find the arbitrage portfolio has (statistically and economically) significant alphas relative to several popular asset pricing models and annualized Sharpe ratios ranging from 1.31 to 1.66.
Keywords: Arbitrage, Alpha, Factor Model, Hedge, Principal Components
JEL Classification: G10, G11, G12
Suggested Citation: Suggested Citation