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Bayesian solutions for the factor zoo: we just ran two quadrillion models

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  • Bryzgalova, Svetlana
  • Huang, Jiantao
  • Julliard, Christian

Abstract

We propose a novel, and simple, Bayesian estimation and model selection procedure for crosssectional asset pricing. Our approach, that allows for both tradable and non-tradable factors, and is applicable to high dimensional cases, has several desirable properties. First, weak and spurious factors lead to diffuse, and centered at zero, posteriors for their market price of risk, making such factors easily detectable. Second, posterior inference is robust to the presence of such factors. Third, we show that flat priors for risk premia lead to improper marginal likelihoods, rendering model selection invalid. Therefore, we provide a novel prior, that is diffuse for strong factors but shrinks away useless ones, under which posterior probabilities are well behaved, and can be used for factor and (non necessarily nested) model selection, as well as model averaging, in large scale problems. We apply our method to a very large set of factors proposed in the literature, and analyse 2.25 quadrillion possible models, gaining novel insights on the empirical drivers of asset returns.

Suggested Citation

  • Bryzgalova, Svetlana & Huang, Jiantao & Julliard, Christian, 2020. "Bayesian solutions for the factor zoo: we just ran two quadrillion models," LSE Research Online Documents on Economics 118924, London School of Economics and Political Science, LSE Library.
  • Handle: RePEc:ehl:lserod:118924
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    3. Siddhartha Chib & Simon C. Smith, 2024. "Factor Selection and Structural Breaks," Finance and Economics Discussion Series 2024-037, Board of Governors of the Federal Reserve System (U.S.).
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    More about this item

    Keywords

    cross-sectional asset pricing; factor models; model evaluation; multiple testing; data mining; p-hacking; Bayesian methods;
    All these keywords.

    JEL classification:

    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • C11 - Mathematical and Quantitative Methods - - Econometric and Statistical Methods and Methodology: General - - - Bayesian Analysis: General
    • C12 - Mathematical and Quantitative Methods - - Econometric and Statistical Methods and Methodology: General - - - Hypothesis Testing: General
    • C52 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Model Evaluation, Validation, and Selection
    • C59 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Other

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