Forward Selection Fama-MacBeth Regression with Higher-Order Asset Pricing Factors

Nicola Borri, Denis Chetverikov, Yukun Liu and Aleh Tsyvinski
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Nicola Borri: LUISS University
Denis Chetverikov: UCLA
Yukun Liu: University of Rochester
Aleh Tsyvinski: Yale University

No 2437, Cowles Foundation Discussion Papers from Cowles Foundation for Research in Economics, Yale University

Abstract: We show that the higher-orders and their interactions of the common sparse linear factors can effectively subsume the factor zoo. To this extend, we propose a forward selection Fama-MacBeth procedure as a method to estimate a high-dimensional stochastic discount factor model, isolating the most relevant higher-order factors. Applying this approach to terms derived from six widely used factors (the Fama-French five-factor model and the momentum factor), we show that the resulting higher-order model with only a small number of selected higher-order terms significantly outperforms traditional benchmarks both in-sample and out of-sample. Moreover, it effectively subsumes a majority of the factors from the extensive factor zoo, suggesting that the pricing power of most zoo factors is attributable to their exposure to higher-order terms of common linear factors.

Pages: 67 pages
Date: 2025-03-30
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