Linear Factor Models and the Estimation of Expected Returns

54 Pages Posted: 17 Apr 2024

See all articles by Cisil Sarisoy

Cisil Sarisoy

Board of Governors of the Federal Reserve System

Peter de Goeij

Tilburg University

Bas J. M. Werker

Tilburg University - Center for Economic Research (CentER)

Multiple version iconThere are 2 versions of this paper

Date Written: March, 2024

Abstract

This paper analyzes the properties of expected return estimators on individual assets implied by the linear factor models of asset pricing, i.e., the product of β and λ. We provide the asymptotic properties of factor--model--based expected return estimators, which yield the standard errors for risk premium estimators for individual assets. We show that using factor-model-based risk premium estimates leads to sizable precision gains compared to using historical averages. Finally, inference about expected returns does not suffer from a small--beta bias when factors are traded. The more precise factor--model--based estimates of expected returns translate into sizable improvements in out--of--sample performance of optimal portfolios.

Keywords: Cross section of expected returns, Risk premium, Small β’s

JEL Classification: C13, G11, C38

Suggested Citation

Sarisoy, Cisil and de Goeij, Peter and Werker, Bas J.M., Linear Factor Models and the Estimation of Expected Returns (March, 2024). FEDS Working Paper No. 2024-14, Available at SSRN: https://ssrn.com/abstract=4797202 or http://dx.doi.org/10.17016/FEDS.2024.014

Cisil Sarisoy (Contact Author)

Board of Governors of the Federal Reserve System ( email )

20th Street and Constitution Avenue NW
Washington, DC 20551
United States

Peter De Goeij

Tilburg University ( email )

P.O. Box 90153
Room I607
Tilburg, Noord-Brabant 5000 LE
Netherlands
+31134662083 (Phone)

Bas J.M. Werker

Tilburg University - Center for Economic Research (CentER) ( email )

Econometrics and Finance Group
5000 LE Tilburg
Netherlands

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