Testing Asset Pricing Model with Non-Traded Factors: A New Method to Resolve (Measurement/Econometric) Issues in Factor-Mimicking Portfolio

Abstract

We suggest the factor-mimicking portfolio (FMP) of a nontraded factor should jointly minimize the mispricing component of stock returns in a beta-pricing model. We also propose a novel method for constructing FMPs and measure the risk premiums of nontraded factors. Several of the macroeconomic factors of FMPs constructed by our method are related to the cross-sectional covariance of individual stock or bond returns. Consumption growth, inflation, and the unemployment rate command equity premiums; consumption growth and industrial production command bond premiums.

Keywords: factor-mimicking portfolios, nontraded factors, risk premium

JEL Classification: G10, G12, G11