Investor Psychology and Tests of Factor Pricing Models
40 Pages Posted: 26 Nov 2005
Date Written: November 20, 2005
Abstract
We provide a model with overconfident risk neutral investors, and therefore no risk premia, in which a price-based portfolio such as HML earns positive expected returns and loads on fundamental macroeconomic variables. Furthermore, loadings on such portfolios are proxies for mispricing, and therefore forecast cross-sectional returns, even after controlling for characteristics such as book-to-market. Thus, an empirical finding that covariances incrementally predict returns does not distinguish rational factor pricing from a setting with no risk premia. The analysis reconciles the high risk (market betas) of low book-to-market firms with their low expected returns, and offers new empirical implications to distinguish alternative theories.
Keywords: factor models, overconfidence, Fama-French factors, covariance risk
JEL Classification: G00, G10, G12, G15
Suggested Citation: Suggested Citation
Register to save articles to
your library
Recommended Papers
-
Default Risk in Equity Returns
By Maria Vassalou and Yuhang Xing
-
News Related to Future GDP Growth as a Risk Factor in Equity Returns
-
News Related to Future GDP Growth as Risk Factors in Equity Returns
-
By John Y. Campbell, Jens Hilscher, ...
-
By John Y. Campbell, Jens Hilscher, ...
-
Forecasting Default with the Kmv-Merton Model
By Sreedhar T. Bharath and Tyler Shumway
-
Exchange Rate and Foreign Inflation Risk Premiums in Global Equity Returns
-
By Maria Vassalou and Yuhang Xing
-
Bankruptcy Prediction With Industry Effects
By Sudheer Chava and Robert A. Jarrow
