Test Assets and Weak Factors
110 Pages Posted: 20 Jan 2021 Last revised: 23 Jun 2022
Date Written: January 17, 2021
Weak factors – factors to which test assets are only weakly exposed – represent an important concern in empirical asset pricing. We propose a novel methodology to address this issue, supervised-PCA (SPCA). SPCA iterates a supervised asset selection step, in which only informative test assets are selected, and a principal-component estimation step to extract factors. It can be used to estimate risk premia and diagnose factor models even when weak factors are present and not all true factors are observed. We derive SPCA’s asymptotic properties and illustrate several empirical applications of our methodology.
Keywords: Supervised PCA, SPCA, PCA, risk premium, factor models, APT, Ridge, Lasso, stochastic discount factor
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