Working Paper: NBER ID: w17285
Authors: Xiaoji Lin; Lu Zhang
Abstract: We question a deep-ingrained doctrine in asset pricing: If an empirical characteristic-return relation is consistent with investor "rationality," the relation must be "explained" by a risk factor model. The investment approach changes the big picture of asset pricing. Factors formed on characteristics are not necessarily risk factors: Characteristics-based factor models are linear approximations of firm-level investment returns. The evidence that characteristics dominate covariances in horse races does not necessarily mean mispricing: Measurement errors in covariances are more likely to blame. Most important, the investment approach completes the consumption approach in general equilibrium, especially for cross-sectional asset pricing.
Keywords: Asset Pricing; Investment Approach; Characteristics; Covariances; General Equilibrium
JEL Codes: D51; D53; D58; E22; E44; G12; G14; G31
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| characteristics (L15) | expected returns (G17) |
| covariances (C10) | expected returns (G17) |
| characteristics (L15) | covariances (C10) |