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Linear Factor Models and the Estimation of Expected Returns

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Abstract

This paper analyzes the properties of expected return estimators on individual assets implied by the linear factor models of asset pricing, i.e., the product of β and λ. We provide the asymptotic properties of factor--model--based expected return estimators, which yield the standard errors for risk premium estimators for individual assets. 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.

Suggested Citation

  • Cisil Sarisoy & Bas J.M. Werker, 2024. "Linear Factor Models and the Estimation of Expected Returns," Finance and Economics Discussion Series 2024-014, Board of Governors of the Federal Reserve System (U.S.).
    • Handle: RePEc:fip:fedgfe:2024-14
    DOI: 10.17016/FEDS.2024.014
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    More about this item

    Keywords

    Cross section of expected returns; Risk premium; Small β’s;
    All these keywords.

    JEL classification:

    • C13 - Mathematical and Quantitative Methods - - Econometric and Statistical Methods and Methodology: General - - - Estimation: General
    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
    • C38 - Mathematical and Quantitative Methods - - Multiple or Simultaneous Equation Models; Multiple Variables - - - Classification Methdos; Cluster Analysis; Principal Components; Factor Analysis

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