Factor Models with Downside Risk

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