Spurious Factors in Linear Asset Pricing Models, R&R at The Review of Financial Studies
When a risk factor has small covariance with asset returns, risk premia in the linear asset pricing models are no longer identified. Weak factors, similar to weak instruments, make the usual estimation techniques unreliable. When included in the model, they generate spuriously high significance levels of their own risk premia estimates, overall measures of fit and may crowd out the impact of the true sources of risk. I develop a new approach to the estimation of cross-sectional asset pricing models that : a) provides simultaneous model diagnostics and parameter estimates; b) automatically removes the effect of spurious factors; c) restores consistency and asymptotic normality of the parameter estimates, as well as the accuracy of standard measures of fit; d) performs well in both small and large samples. I provide new insights on the pricing ability of various factors proposed in the literature. In particular, I identify a set of robust factors (e.g. Fama-French ones, but not only), and those that suffer from severe identification problems that render the standard assessment of their pricing performance unreliable (e.g. consumption growth, human capital proxies and others).
The Consumption Risk of Bonds and Stocks with Christian Julliard
Aggregate consumption growth reacts slowly, but signicantly, to bond and stock return innovations. As a consequence, slow consumption adjustment (SCA) risk, measured by the reaction of consumption growth accumulated over many quarters following a return, can explain most of the cross-sectional variation of expected bond and stock returns. Moreover, SCA shocks explain about a quarter of the time series variation in consumption growth, a large part of the time series variation of stock returns, and a significant (but small) fraction of the time series variation of bond returns, and have substantial predictive power for the future consumption growth.
Work in Progress
Forecasting the Term Structure of Interest Rates with Unspanned Factors