Are characteristic interactions important to the cross-section of expected returns?

Abstract

Characteristic interactions play an important role in describing the cross-section of expected returns. I use a Fama-Macbeth regression modified to accommodate more vari- ables than observations to study the cross-sectional relationship between characteristic interactions and expected returns. The modified Fama-Macbeth regression uses a form of dimension reduction called an envelope, which does not require variable selection or slope regularization. I use the method to estimate the information in 3,655 character- istic interactions about the cross-section of expected returns. About 100 interactions have incremental information about expected returns. Standard long-short portfolios constructed from interaction-based estimates of expected returns have significant risk- adjusted returns compared to standard factor models.

Keywords: cross-sectional expected stock returns, firm characteristics, statistical envelopes, dimension reduction

JEL Classification: C53, C55, C58, G12, G14, G17