Fundamental Properties of Linear Factor Models

Abstract

We study conditional linear factor models in the context of asset pricing panels. Our analysis focuses on conditional means and covariances to characterize the cross-sectional and inter temporal properties of returns and factors as well as their interrelationships. We also review the conditions outlined in Kozak and Nagel (2024) and show how the conditional mean variance efficient portfolio of an unbalanced panel can be spanned by low-dimensional factor portfolios, even without assuming invertibility of the conditional covariance matrices. Our analysis provides a comprehensive foundation for the specification and estimation of conditional linear factor models.

Keywords: asset pricing, factor models, characteristics, covariances, meanvariance efficient portfolio, stochastic discount factor, covariance estimation

JEL Classification: G11, G12, C38