Risk Factors’ Cpdag Roots and the Cross-Section of Expected Returns

44 Pages Posted: 2 Nov 2020 Last revised: 13 Oct 2021

See all articles by Fernando Moraes

Fernando Moraes

Insper

Rodrigo De-Losso

University of São Paulo (USP) - Department of Economics

Date Written: January 23, 2021

Abstract

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

Tassinari Moraes, Fernando and De-Losso, Rodrigo, Risk Factors’ Cpdag Roots and the Cross-Section of Expected Returns (January 23, 2021). Available at SSRN: https://ssrn.com/abstract=3691336 or http://dx.doi.org/10.2139/ssrn.3691336

Fernando Tassinari Moraes (Contact Author)

Insper ( email )

R Quata 300
Sao Paulo, 04542-030
Brazil

Rodrigo De-Losso

University of São Paulo (USP) - Department of Economics ( email )

Av. Prof. Luciano Gualberto 908
Sao Paulo SP, 05508-010
Brazil
551130930957 (Phone)

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