Flow-Based Asset Pricing: A Factor Framework of Cross-sectional Price Impacts

Abstract

We develop a new empirical framework that unifies the risk-based and demand-based approaches to studying the pricing implications of noisy flows. In our framework, price fluctuations follow a factor structure. Flows into factor portfolios change factor risk exposures, which drive time-series fluctuations in factor premiums. In the cross section, each asset’s price impact depends on its risk exposure to the factors. To build this framework, we introduce flows into classical portfolio tools, including the Sharpe ratio, Fama-MacBeth regression, Fama-French portfolios, and Gibbons-Ross-Shanken test. We estimate the model using U.S. equity mutual fund flows data. The model-implied strategy that optimally profits from flows improves the investment performance of most existing firm characteristics-based anomaly portfolios.

Keywords: cross section, factor, flow, price impact, risk

JEL Classification: G12