Seminar 217, Risk Management: Estimating Latent Asset-Pricing Factors

Seminar | January 24 | 11 a.m.-1 p.m. | 639 Evans Hall

 Speaker: Markus Pelger (joint with Martin Lettau), Stanford

 Center for Risk Management Research

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. Our estimator searches for factors with a high Sharpe-ratio 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 and stock data we find factors with Sharpe-ratios more than twice as large as those based on conventional PCA. Our factors accommodate a large set of anomalies better than notable four- and five-factor alternative models.

 jschellenberg@berkeley.edu