Correcting Asset Pricing Models

62 Pages Posted: 28 May 2021 Last revised: 17 Mar 2022

See all articles by Sina Ehsani

Sina Ehsani

Northern Illinois University

Juhani T. Linnainmaa

Dartmouth College - Tuck School of Business; National Bureau of Economic Research (NBER)

Date Written: March 15, 2022

Abstract

Equilibrium asset pricing models prescribe a correspondence between assets' risk exposures and premiums. Empirical factor models do not, however, satisfy this relationship. We show that a portfolio sorted on a multi-factor model's alphas is the optimal correction to this problem. This correction factor is a generalization of the betting-against-beta (BAB) factor. Whereas the BAB factor adjusts for the flatness in the security market line, the correction factor simultaneously adjusts for all such distortions. Augmenting the Fama-French five-factor model with its correction factor increases the model's out-of-sample Sharpe ratio by 40%, increases its power to explain the cross section of returns, and lowers its errors in pricing 208 anomalies.

Keywords: Beta, Betting against beta, Security market line, Factor model, Mean-variance efficiency

JEL Classification: G11, G12, G40

Suggested Citation

Ehsani, Sina and Linnainmaa, Juhani T., Correcting Asset Pricing Models (March 15, 2022). Available at SSRN: https://ssrn.com/abstract=3855066 or http://dx.doi.org/10.2139/ssrn.3855066

Sina Ehsani

Northern Illinois University ( email )

Chicago, IL 60115
United States

Juhani T. Linnainmaa (Contact Author)

Dartmouth College - Tuck School of Business ( email )

Hanover, NH 03755
United States

HOME PAGE: http://www.tuck.dartmouth.edu/faculty/faculty-directory/juhani-linnainmaa

National Bureau of Economic Research (NBER) ( email )

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

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