Estimating Latent Asset-Pricing Factors

Martin Lettau and Markus Pelger

No 24618, NBER Working Papers from National Bureau of Economic Research, Inc

Abstract: We develop an estimator for latent factors in a large-dimensional panel of financial data that can explain expected excess returns. Statistical factor analysis based on Principal Component Analysis (PCA) has problems identifying factors with a small variance that are important for asset pricing. We generalize PCA with a penalty term accounting for the pricing error in expected returns. Our estimator searches for factors that can explain both the expected return and covariance structure. We derive the statistical properties of the new estimator and show that our estimator can find asset-pricing factors, which cannot be detected with PCA, even if a large amount of data is available. Applying the approach to portfolio data we find factors with Sharpe-ratios more than twice as large as those based on conventional PCA and with significantly smaller pricing errors.

JEL-codes: C14 C38 C52 G12 (search for similar items in EconPapers)
Date: 2018-05
New Economics Papers: this item is included in nep-ore
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Citations: View citations in EconPapers (12)

Published as Martin Lettau & Markus Pelger, 2020. "Estimating latent asset-pricing factors," Journal of Econometrics, .

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Related works:
Journal Article: Estimating latent asset-pricing factors (2020)
Working Paper: Estimating Latent Asset-Pricing Factors (2018)
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