Common Risk Factors in the Returns on Stocks, Bonds (and Options), Redux

Abstract

Are there risk factors that are pervasive across major classes of corporate securities: stocks, bonds, and options? We employ a novel econometric procedure that relies on asset characteristics to estimate a conditional latent factor model. A common risk factor structure prominently emerges across asset classes. Several common factors explain a substantial amount of time-series variation of individual asset returns across all three asset classes, and have sizable Sharpe ratios. Several of our factors are highly correlated with some of asset-class-specific factors as well as macroeconomic and financial variables. While a small set of common factors does not fully capture the cross-section of average returns, imposing the factor structure is useful in practice, especially in out-of-sample analysis. A mean-variance efficient portfolio that utilizes asset characteristics achieves a high Sharpe ratio as different asset classes hedge each other's exposures to the common factors. 

Keywords: common factors, linear factor models, cross section, stock returns, corporate bond, option, nonparametric

JEL Classification: G0, G10, G12, G13