Factor Models with Downside Risk

116 Pages Posted: 11 Oct 2021 Last revised: 15 Nov 2022

See all articles by Daniele Massacci

Daniele Massacci

King's College London

Lucio Sarno

University of Cambridge - Judge Business School; Centre for Economic Policy Research (CEPR)

Lorenzo Trapani

University of Nottingham - School of Economics

Date Written: October 6, 2021

Abstract

We propose a conditional model of asset returns in the presence of common factors and downside risk. Specifically, we generalize existing latent factor models in three ways: we show how to estimate the threshold which identifies the 'disappointment' event triggering the bad state of the world; we permit different factor structures for asset returns in good and bad states; we show how to recover the observable factors' risk premia from the estimated latent ones in different states. The usefulness of the model is illustrated through two applications to cross-sections of asset returns in equity markets and other major asset classes.

Keywords: factor models, downside risk, risk premium, conditional asset pricing

JEL Classification: G12, G15, C12, C31, C32

Suggested Citation

Massacci, Daniele and Sarno, Lucio and Trapani, Lorenzo, Factor Models with Downside Risk (October 6, 2021). Available at SSRN: https://ssrn.com/abstract=3937321 or http://dx.doi.org/10.2139/ssrn.3937321

Daniele Massacci

King's College London ( email )

United Kingdom

Lucio Sarno (Contact Author)

University of Cambridge - Judge Business School ( email )

Trumpington Street
Cambridge, CB2 1AG
United Kingdom

Centre for Economic Policy Research (CEPR)

London
United Kingdom

Lorenzo Trapani

University of Nottingham - School of Economics ( email )

Sir Clive Granger Building
Universit Park
Nottingham, Nottinghamshire NG72RD
United Kingdom

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