Linear Factor Models and the Estimation of Expected Returns

Cisil Sarisoy and Bas Werker
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Cisil Sarisoy: https://www.federalreserve.gov/econres/cisil-sarisoy.htm

No 2024-014, Finance and Economics Discussion Series from Board of Governors of the Federal Reserve System (U.S.)

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.

Keywords: Cross section of expected returns; Risk premium; Small β’s (search for similar items in EconPapers)
JEL-codes: C13 C38 G11 (search for similar items in EconPapers)
Pages: 54 p.
Date: 2024-03-28
New Economics Papers: this item is included in nep-ecm
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Persistent link: https://EconPapers.repec.org/RePEc:fip:fedgfe:2024-14

DOI: 10.17016/FEDS.2024.014

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