Cross-Section Without Factors: Correlation Risk, Strings and Asset Prices

Walter Distaso, Antonio Mele and Grigory Vilkov
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Walter Distaso: Imperial College Business School

No 20-119, Swiss Finance Institute Research Paper Series from Swiss Finance Institute

Abstract: Many asset pricing theories treat the cross-section of expected returns, volatility and correlations as quantities driven by common factors. We formulate and estimate a model without such factors, but with a continuum of securities that have returns driven by a string. Our arbitrage restrictions require that any asset premium links to the granular exposure of the asset returns to shocks in all other asset returns: an average correlation premium. The model predictions uncover fresh properties of big stocks. Big stocks display a high degree of market connectivity in bad times, but also work as correlation hedges: they contribute to a negative fraction of the average 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.

Keywords: correlation premium; premium for correlation risk; cross-section of returns; big stocks; arbitrage pricing; string models; implied correlation (search for similar items in EconPapers)
JEL-codes: G11 G12 G13 G17 (search for similar items in EconPapers)
Pages: 53 pages
Date: 2020-09
New Economics Papers: this item is included in nep-ore and nep-rmg
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Persistent link: https://EconPapers.repec.org/RePEc:chf:rpseri:rp20119

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