Which (Nonlinear) Factor Models?

51 Pages Posted: 25 Apr 2023

See all articles by Caio Almeida

Caio Almeida

Princeton University

Gustavo Freire

Erasmus School of Economics; Tinbergen Institute

Date Written: April 17, 2023


Traditional asset pricing tests boil down to evaluating the maximum Sharpe ratio obtained from the factors in a given model. This implicitly assumes the linear stochastic discount factor (SDF) that prices the factors as the asset pricing model. We generalize this approach by considering a comprehensive family of nonlinear SDFs pricing the model factors. The relevant metric for model comparison becomes the maximum Sharpe ratio of the mimicking portfolio constructed by projecting the nonlinear SDF onto the test assets. We show that nonlinearities matter empirically for both absolute and relative pricing performance of leading factor models.

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? (April 17, 2023). Available at SSRN: https://ssrn.com/abstract=4421179 or http://dx.doi.org/10.2139/ssrn.4421179

Caio Almeida (Contact Author)

Princeton University ( email )

26 Prospect Avenue
Princeton, NJ 08540
United States

Gustavo Freire

Erasmus School of Economics ( email )

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

Tinbergen Institute ( email )

Burg. Oudlaan 50
Rotterdam, 3062 PA

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