Risk Factors’ Cpdag Roots and the Cross-Section of Expected Returns
44 Pages Posted: 2 Nov 2020 Last revised: 13 Oct 2021
Date Written: January 23, 2021
The asset pricing literature has produced hundreds of risk factor candidates aimed at explaining the cross-section of expected excess returns, although risk factors which are in fact capable of providing independent information remain an open question. In this paper, we propose a new methodology that seeks to reduce risk factor predictor dimensions by estimating the joint risk factor distribution with CPDAG (complete partial directed acyclic graph), in addition to selecting the CPDAG root as the only new risk factor candidate set. This methodology has an advantage over other variable selection methodologies since it presents a theoretical motivation. Our approach yields a significant shrinkage in the original set of risk factors, whereas our findings lead to sparser model to those attained with other methods proposed by factor zoo-related research papers and, yet, present better in and out-of-sample R^2 results when confronted with the majority of those factor zoo models.
Keywords: Risk factors, factor zoo, DAG, CPDAG
JEL Classification: G12, C55, D85
Suggested Citation: Suggested Citation