Linear Factor Models and the Estimation of Expected Returns
53 Pages Posted: 20 Apr 2016 Last revised: 6 Feb 2024
Date Written: January 20, 2024
Abstract
This paper analyzes the properties of expected return estimators on individual assets/portfolios implied by the linear factor models of asset pricing, i.e., the product of factor exposures and prices of risk. We provide the asymptotic properties of factor-model-based expected return estimators, which yield the standard errors for risk premium estimators for individual assets/portfolios. 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 Betas.
JEL Classification: C13, C38, G11
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