Cross-section without factors: a string model for expected returns

Walter Distaso, Antonio Mele and Grigory Vilkov

Quantitative Finance, 2024, vol. 24, issue 6, 693-718

Abstract: Many asset pricing models assume that expected returns are driven by common factors. We formulate a model where returns are driven by a string, and no-arbitrage restricts each expected return to capture the asset's granular exposure to all other asset returns: a correlation premium. The model predicts fresh properties for big stocks, which display higher connectivity in bad times, but also work as correlation hedges: they contribute to a negative fraction of the correlation premium, and portfolios that are more exposed to them command a lower premium. The string model performs at least as well as many existing linear factor models.

Date: 2024
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DOI: 10.1080/14697688.2024.2357189

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