Which (Nonlinear) Factor Models?

Caio Almeida and Gustavo Freire
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Caio Almeida: Princeton University
Gustavo Freire: Erasmus University Rotterdam

Working Papers from Princeton University. Economics Department.

Abstract: Traditional asset pricing tests boil down to evaluating the maximum Sharpe ratio obtained from the factors in a given model. This implicitly assumes the linear stochastic discount factor (SDF) that prices the factors as the asset pricing model. We generalize this approach by considering a comprehensive family of nonlinear SDFs pricing the model factors. The relevant metric for model comparison becomes the maximum Sharpe ratio of the mimicking portfolio constructed by projecting the nonlinear SDF onto the test assets. We show that nonlinearities matter empirically for both absolute and relative pricing performance of leading factor models.

Keywords: Model Comparison; Factor Models; Anomalies; Stochastic Discount Factor; Nonlinearities (search for similar items in EconPapers)
JEL-codes: C52 G11 G12 (search for similar items in EconPapers)
Date: 2023-04
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Persistent link: https://EconPapers.repec.org/RePEc:pri:econom:2023-07

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