Which (Nonlinear) Factor Models?

60 Pages Posted: 25 Apr 2023 Last revised: 27 Nov 2023

See all articles by Caio Almeida

Caio Almeida

Princeton University - Bendheim Center for Finance

Gustavo Freire

Erasmus University Rotterdam (EUR) - Erasmus School of Economics (ESE); Tinbergen Institute; Erasmus Research Institute of Management (ERIM)

Date Written: November 20, 2023

Abstract

We extend traditional tests of factor models to incorporate nonlinearities. The metric for model evaluation becomes the Sharpe ratio of the mimicking portfolio of a nonlinear stochastic discount factor (SDF) pricing the model factors. Empirically, we investigate the implications of an economically meaningful family of nonlinear SDFs for evaluating popular factor models. We find that, relative to the linear case, introducing nonlinearities substantially improves pricing performance and changes rankings among competing models. The preferred model depends on the test assets: unlike the linear approach, test assets are relevant for model comparison as they are needed to mimic nonlinearities in the factors.

Keywords: Model Comparison, Factor Models, Anomalies, Stochastic Discount Factor, Nonlinearities

JEL Classification: C52, G11, G12

Suggested Citation

Almeida, Caio and Freire, Gustavo, Which (Nonlinear) Factor Models? (November 20, 2023). Available at SSRN: https://ssrn.com/abstract=4421179 or http://dx.doi.org/10.2139/ssrn.4421179

Caio Almeida (Contact Author)

Princeton University - Bendheim Center for Finance ( email )

20 Washington Rd
Princeton, NJ Mercer 08540
United States

Gustavo Freire

Erasmus University Rotterdam (EUR) - Erasmus School of Economics (ESE) ( email )

P.O. Box 1738
3000 DR Rotterdam, NL 3062 PA
Netherlands

HOME PAGE: http://https://www.eur.nl/people/gustavo-freire

Tinbergen Institute ( email )

Burg. Oudlaan 50
Rotterdam, 3062 PA
Netherlands

HOME PAGE: http://https://tinbergen.nl/person/2029/gustavo-freire

Erasmus Research Institute of Management (ERIM) ( email )

P.O. Box 1738
3000 DR Rotterdam
Netherlands

HOME PAGE: http://https://www.erim.eur.nl/people/gustavo-freire/

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