Finance and Economics Discussion Series (FEDS)
March 2024
Linear Factor Models and the Estimation of Expected Returns
Cisil Sarisoy, Peter de Goeij, and Bas J.M. Werker
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
DOI: https://doi.org/10.17016/FEDS.2024.014
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