Factor Pricing

Advanced Asset Pricing
Factor Pricing and Beta Models

Dr. des. Matthias Huss
Wirtschaftswissenschaftliches Zentrum der Universitt Basel
Abteilung fr Finanzmarkttheorie
4 April 2013
Introduction Factor Pricing Models and the APT Estimating Factor Models Empirical Application
Table of Contents
1 Introduction
Linear Factor Models and Motivation
2 Factor Pricing Models and the APT
Factor Pricing Models
Exact Factor Pricing
Approximate Factor Pricing
3 Estimating Factor Models
Time-Series Regression
Cross-Sectional Regression
Fama MacBeth (1973)
Mimicking Portfolios
4 Empirical Application
Dr. des. Matthias Huss Universitt Basel - WWZ - Abteilung fr Finanzmarkttheorie
AAP Factor Pricing and Beta Models
Motivation for Factor Models
Despite their beauty, the consumption based models do not work very
well in practice.
Consumption aggregates
are not immediately observable
may not be measurable with sucient precision, and
are available at a low frequency only.
Further, the consumption based models are stated in continuous time;
empirical applications, however, require a discrete time framework.
Thus, in empirical applications, we (often) need to replace the
consumption based expression for marginal utility by some other
factors...
Motivation for Factor Models
Factor models exactly do this.
But they start from a very dierent approach.
Factor models simply build on the observation that asset returns have a
tendency to move together, i.e. asset returns are correlated.
These movements are associated with the movements of common risk
factors (whatever they may be) which inuence the returns of many or
even all assets likewise.
According to factor models, only a few economy-wide pervasive factors
are sucient to represent the systematic risk of assets.
In the spirit of ICAPM or C-CAPM, a factor should proxy for marginal
utility or consumption growth.
What is a Risk Factor?
Generally, a risk factor can be anything that commonly aects the
returns of many or even all assets in a systematic way.
There are three classes of risk factors:
Economic Factors are based on economic theory and/or intuition,
often macroeconomic factors. Among those that have proved to be
successful are: Industrial Production growth, (unanticipated) changes
in ination, the term premium and the default premium (e.g. Chen et
al (1986)). Advantage: they readily provide an economic
interpretation of sensitivities and risk premia.
Characteristics Based Factors are typically returns on portfolios of
traded assets that are formed on characteristics such as size of B/M.
Fama/French(1993,1996) etc. They often produce high R
2
, but it is
not clear what risks they represent.
Statistical Factors are derived by factor analysis or principal
components. This helps to determine the number of factors required
to represent systematic risk, but the factors are dicult to interpret.
Linear Factor Models
We will concentrate on the most popular class of factor models:
Linear factor models.
An assets sensitivity, or exposure, to (unexpected) changes in the
common factors can be estimated from a (multiple) time-series regression
of asset returns on either factors f or the factors unexpected changes

f
R
it
= a
i
+
K
j=1
ij
f
jt
+
it
, (1)
where r
it
denotes the return of asset i at time t and
ij
represents the
assets exposure to the systematic risk represented by factor j . The
variables a
i
and
it
are the intercept and the residuals of the regression
and are both specic for asset i .
General Factor Pricing Models
Factor models are a statistical decomposition of asset returns into
systematic and idiosyncratic risk only.
But the central economic question in asset pricing is: Why do average
returns vary across assets?
Factor (or beta) pricing models use the statistical decomposition of asset
returns to derive a statement about the assets expected returns.
Idea: As idiosyncratic risk can be (completely) diversied away, only the
assets systematic risk is compensated with a risk premium.
In other words: The factor structure determines the price of an asset.
General Factor Pricing Models II
Linear factor pricing models state that the expected return on an asset is
a linear function of its factor betas.
E[R
e
i
] =
(2)
That is, if all assets are consistently priced, this imposes a restriction on
the intercept a
i
in the return representation given by equation (1) and
the return of an asset can be decomposed into (i) an expected return
component, which is linear in the betas, (ii) a systematic component that
links the assets return to unexpected changes of the risk factors, which is
also determined by the factor structure, and (iii) a residual idiosyncratic
component.
R
e
it
=
K
j=1
ij
j
+
K
j=1
ij
f
jt
+
it
. (3)
We only require the Law Of One Price (LOOP) to conclude the
argument.
General Factor Pricing Models II
We start with the statistical characterization of an assets return:
R
i
= E[R
i
] +
K
j=1
ij
f
j
+
i
= E[R
i
] +
f +
i
(4)
Note, dierent to equation (1), the intercept is E[R
i
], not a
i
, as we want
to add some economic content to the equation.
However, equation 4 is still a purely statistical representation of returns.
If we choose

f = [1 (f E[f ])], E[R
i
] is simply the sample mean of R
i
.
E[R
i
] is NOT (yet) the prediction of a model!
General Factor Pricing Models III
If betas are dened as regression coecients, the residuals are
uncorrelated with the factors by construction and have a zero mean.
E[
i
] = E[
i
f ] = 0
The basic economic content that keeps the equation from describing just
any arbitrary set of returns is the additional restriction that the residuals
are cross-sectionally uncorrelated.
E[
i
j
] = 0 The intuition is that the factor structure is complete.
The assumption implies a restriction on the covariance matrix of returns.
Assuming a single factor for simplicity
cov(R
i
, R
j
) = E[(i
f +
i
)(j
f +
j
)] =
i
2
(f ) +
_
2
1
0 0
0
2
2
0
0 0
.
.
.
_
_
(5)
Exact Factor Pricing by LOOP
Exact factor pricing relates to the case when there is no error term in the
return decomposition, i.e.
i
= 0,
R
i
= E[R
i
] 1 +
f . (6)
Then, the Law of one price (LOOP) implies
p(R
i
) = E[R
i
] p(1) +
i
p(
f ), (7)
where p() denotes prices.
As p(R
i
) = 1 and p(1) = 1/R
f
, it follows that
E[R
i
] = R
f
+
i
[R
f
p(
f )]
. .
= R
f
+
i
. (8)
Expected returns are linear in their betas and s are related to the
prices of factors.
Exact Factor Pricing by Arbitrage I
An arbitrage portfolio is one that
requires no investment:
w
p
= 0
carries no systematic risk:
w
p
= 0
To exclude arbitrage, the (net-zero investment) portfolio must have an
expected return of zero, that is
E[R
i
]
w
p
= 0 (9)
where E[R
i
] = R
f
+ E[R
e
i
].
Exact Factor Pricing by Arbitrage II
The system of equations can be compactly written as
_

E[R
i
]
_
w
p
= 0 (10)
Despite the trivial solution (w
p
= 0), the (homogeneous) system of
equations has a solution only, if the matrix is singular, i.e. does not have
full rows or column rank. That is the case if the rows or columns are
linearly dependent.
This is the case if we choose
E[R
i
] = 1
0
+ (11)
For a risk-free asset ( = 0) this implies that
E[R
0
] = R
f
=
0
(12)
which means in terms of excess returns
E[R
e
i
] =
(13)
Approximate Arbitrage Pricing
So far, we have assumed no idiosyncratic risk, i.e.
i
= 0.
But actual returns will typically not have an exact factor structure, but
rather exhibit some idiosyncratic risk.
Can the APT be saved if this assumption is relaxed?
The answer is yes, and the rst point is rather trivial. The APT will hold,
at least approximately, when the
i
are small.
A good indication is to look at the R
2
of the factor regression, since
var(
i
)
var(R
i
)
= 1 R
2
. (14)
Thus, a high R
2
implies that the (APT) model is an acceptable
approximation.
Approximate Arbitrage Pricing II
Consider an (equally weighted) portfolio. Then
R
p
=
1
N
N
i =0
R
i
=
1
N
N
i =0
(E[R
i
] +
f +
i
) = ( ) +
1
N
N
i =0
(
i
), (15)
and
var(
p
) = var
_
1
N
N
i =0
i
_
(16)
As long as the variance of
i
is bounded and the factor assumption
E[
i
j
] = 0 holds
lim
N
var(
p
) = 0 (17)
So, it is generally a good idea to test the APT on well-diversied
portfolios, rather than on individual assets!
Traded vs. Non-traded Factors
The task is to estimate betas, the market price of risk (MPR, ) and
then to derive the pricing errors implied by the model and see whether
they are statistically dierent from zero.
For the empirical estimation of the MPR of a particular risk factor, there
is, however, another important distinction to be made that is not
necessarily related to the type of risk the factor represents:
A risk factor can be either traded or not.
Traded Factors are portfolios of traded assets, e.g., the market
portfolio, SMB or HML, etc.
Non-traded Factors typically include macroeconomic factors, e.g., GDP
growth, ination, or interest rates, etc.
Time-Series Regression (Setup)
Estimating a beta pricing model from a time-series regression approach is
only valid when the risk factors of the model are traded, i.e. they are
themselves (excess) returns (e.g., CAPM).
An immediate implication when factors are traded is that the pricing
model also applies to the factors. Considering a single factor for
simplicity, that is:
E[R
e
i
] =
i
(18)
must hold for the factor.
By denition, a factor has a beta of one on itself and betas of zero with
respect to all other factors. This implies:
E[f ] =
f
= 1 (19)
It follows that
f
t
= E[f ] +

f
t
= +

f
t
(20)
Time-Series Regression (Coecients)
The model can be estimated by running time-series regressions of asset
returns on full factor realizations.
R
e
i ,t
=
i
+
i
f
t
+
i ,t
(21)
which gives betas and alphas as the intercept of the regression.
Alphas immediately correspond to the pricing errors.
Note: Do not demean factors, as this takes away the risk premium!
The MPR is calculated as the sample mean (denoted by E
T
) of the factor
= E
T
[f ] (22)
Time-Series Regression (Evaluation)
Theory predicts that the alphas (pricing errors), that is, the intercepts of
the regression should be zero.
On individual security level, this can be veried by simple t-tests.
However, the more interesting test is to verify that the pricing errors are
also jointly zero.
This requires a distribution theory for the joint distribution of alpha
estimates from separate regressions (run side-by-side).
These errors will likely be correlated (E[
i ,t
j,t
] = 0).
Time-Series Regression (Evaluation II)
Assuming
no autocorrelation in the residuals, and
homoscedasticity,
a classic
2
test applies
T
_
1 +
_
E
T
(f )
(f )
_
2
_
1

1

2
N
(23)
where, E
T
(f ) denotes the sample mean,
2
(f ) the sample variance of the
factor and = [
1

2

N
]
is the N 1 vector of regression intercepts.
is the covariance matrix of the residuals, i.e. the sample estimate of

E[
t
t
], i.e.,
=
1
T
T
t=1

t

t
.
Time-Series Regression (Evaluation II)
The test is asymptotically valid (i.e. assumes that
2
(f ) and have
converged to their probability limits). It does not require normality of the
errors (only relies on the CLT), thus is normal.
However, it ignores sources of variation in a nite sample.
The Gibbons, Ross, and Shanken (1989) GRS test
T N 1
N
_
1 +
_
E
T
(f )
(f )
_
2
_
1

1
F
N,TN1
(24)
recognizes sampling variation in

, but requires normal errors.
Time-Series Regression (Evaluation III)
Interpretation of the GRS Test:
By ecient set algebra:
_
q
_
2
=
_
E
T
(f )
(f )
_
2
+
1
(25)
where (
q
/
q
)
2
is the (squared) Sharpe Ratio of the ex post tangency
portfolio formed from the factor and the test assets, and
(E
T
(f )/ (f ))
2
is the Sharpe Ratio of the factor (i.e. that is formed ex
ante).
Using this notation, the GRS test statistic can be rewritten as
T N 1
N
(
q
/
q
)
2
(E
T
(f )/ (f ))
2
_
1 + (E
T
(f )/ (f ))
2
_
F
N,TN1
(26)
Time-Series Regression (Evaluation III)
If the model contains more than one factor, we simply replace the Sharpe
Ratio of the single factor by its natural generalization.
With N test assets and K risk factors the GRS test becomes
T N K
N
_
1 + E
T
(f )
1
E
T
(f )
_
1

1
F
N,TNK
(27)
where
=
1
T
T
t=1
[f
t
E
T
(f )] [f
t
E
T
(f )]
=
1
T
T
t=1

t

t
.
Cross-Sectional Regression (Setup)
When factors are not traded (not returns), the expected value of the
factor is not equal to its risk premium.
Then, the risk premium (MPR, ) of the risk factors has to be
estimated from the cross-section of asset returns.
The beta pricing equation () implies that (i) s are the same for all
assets and (ii) expected returns are linear in their betas.
E[R
e
i
] =
i
(28)
A natural idea is therefore to employ cross-sectional regressions of
average returns on betas to estimate the risk premia of factors.
However, to do this, we rst need the betas of the test assets.
The procedure therefore is two-step.
Cross-Sectional Regression (Setup)
The rst step is to estimate the betas of the test assets by running
time-series regressions of asset returns on factors.
R
e
i ,t
= a
i
+
f
t
+
i ,t
(29)
Note: Dierent to equation (21), the intercept is a
i
, not
i
!
The second step is then to cross-sectionally regress average returns on
betas to estimate the risk premia () and the pricing errors ().
E
T
[R
e
i
] =
i
+
i
(30)
Cross-Sectional Regression (Setup II)
The cross-sectional regression can be run with, or without a constant.
That is, adding a vector of ones to the beta matrix.
As theory predicts the zero-beta excess return should be zero, a constant
is not necessarily required.
However, including a constant, allows for a test whether the constant
turns out to be empirically small.
Clearly: There is also a trade-o between eciency (in the sense of
being close to the null) and robustness of the regression.
Empirically this really makes a dierence!
Cross-Sectional Regression (Coecients by OLS)
For simplicity, we will consider the case of no intercept.
Then, from standard OLS notation the estimates for the risk premia are
= (
)
1
E
T
(R
e
) (31)
and for pricing errors
= E
T
(R
e
)
(32)
respectively.
Cross-Sectional Regression (Evaluation, OLS)
Next, we want to evaluate the model. Again, we need to derive a
distribution that accounts for correlated errors.
These are given by
2
(
) =
1
T
_
(
)
1
)
1
+
f
(33)
and
cov( ) =
1
T
_
I (
)
1
_
I (
)
1
(34)
Test whether all pricing errors are jointly zero:

cov( )
1

2
NK
(35)
Cross-Sectional Regression (Shanken Correction)
However, betas are estimates, not the true parameters, which gives rise
to the so-called errors-in-variables (EIV) problem.
Hence, we need to account for sampling error in (rst-pass) betas, when
computing standard errors of the (second-pass) coecients ( and ).
Shanken (1992) derives the following correction for risk premia estimates
2
(
OLS
) =
1
T
_
(
)
1
)
1
(1 +
1
f
) +
f
(36)
and pricing errors
cov(
OLS
) =
1
T
_
I (
)
1
_
I (
)
1
(1 +
1
f
)
(37)
Importance of this correction?
Fama MacBeth (1973)
Fama MacBeth (Intuition)
Fama and MacBeth suggest an alternative procedure to the
cross-sectional approach discussed so far.
The basic idea is to replace the single cross-sectional regression by T
individual regressions, one regression for each period.
The procedure is historically important and still widely used.
Fama MacBeth (1973)
Fama/MacBeth (Estimation)
First, run a time-series regression to nd the assets betas.
In their original paper, Fama and MacBeth use rolling regressions over a
5 year interval. Todays practice that is followed by most authors,
however, is to estimate a single beta over the entire sample period.
Second, run a cross-sectional regression at each time period t
R
e
i ,t
=
t
+
i ,t
(38)
Then, estimate the MPR and the pricing error as the average of the T
cross-sectional regression coecients.
=
1
T
T
t=1
t
and
i
=
1
T
T
t=1

i ,t
(39)
Fama MacBeth (1973)
Fama/MacBeth (Evaluation)
Fama and McBeth suggest to derive the sampling errors for the estimates
from the (empirical) distribution of the estimates. That is to use the
standard deviation of the cross-sectional regression estimates.
Then, estimate the MPR and the pricing error as the average of the T
cross-sectional regression coecients.
2
(
) =
1
T
2
T
t=1
(
)
2
(40)
and
2
(
i
) =
1
T
2
T
t=1
(
i ,t
)
2
(41)
Intuition: Use the variation in the statistic
t
over time to derive the
variation across samples.
Fama MacBeth (1973)
Fama/MacBeth (Evaluation II)
Joint test of alphas:
cov =
1
T
2
T
t=1
(
t
)(
t
)
(42)
using
cov( )

2
NK
(43)
One of the major advantages of the Fama/MacBeth approach is that it
allows for time-varying betas.
However, the methodology does also not circumvent the EIV problem of
the classical cross-sectional approach.
One way to deal with some of the diculties tied to the two-pass
methodology is to construct a portfolio of traded assets that mimics the
realizations of a non-traded factor.
Such mimicking factor portfolios are linear combinations of traded
assets the replicate the time series of a (non-traded) factor.
They can serve as an articial traded factor, which allows to test asset
pricing models from the time-series approach.
Many authors advocate such a design over the direct application of a
non-traded factor.
Conceptually, mimicking portfolios have close ties to the hedge
portfolio in the ICAPM.
Mimicking Portfolios II
There are two forms of such mimicking portfolios that should be
distinguished from one another:
Maximum Correlation Portfolios maximize the (squared) correlation
with a particular factor.
Unit-Beta Portfolios impose the additional restriction the the
portfolio has a beta of one with respect to the particular factor and
betas of zero with respect to all other factors implied in the model.
Maximum Correlation Portfolios
The idea of a maximum correlation portfolio goes back to Huberman,
Kandel and Stambaugh (1987).
The portfolio weights can be obtained from a linear regression of a
non-traded factor on the space of N excess returns of the chosen base or
test assets.
The regression is of the form
f
t
= c +
R
e
t
+
t
, (44)
where f
t
denotes the vector of (K 1) non-traded factors and r
t
represents the vector of (N 1) excess returns of the base assets.
The matrix of (N K) regression coecients can be interpreted as
the mimicking portfolio weights.
Maximum Correlation Portfolios II
The risk premium of factor mimicking portfolio (f
) is given by
= E [f
] =
E [R
e
] , (45)
where the estimated weights are typically normalized to sum up to one.
If the assets returns, and thus the residuals of the regression are assumed
to be i.i.d., an OLS estimation fullls the requirements of minimizing the
(unweighted) sum of the squared residuals.
It can be shown that the procedure is equivalent to the solution of
maximizing the correlation between the returns of the base assets and the
factor(s).
Maximum Correlation Portfolios III
Maximum correlation portfolios are subject to mainly two diculties.
First, the estimation of the risk premium of a factor mimicking portfolio
is particularly sensitive to the choice of the base assets. Low correlation
between the mimicking portfolio and the original factor often leads to
misrepresentative factor risk premiums (indicated by a low R-squared
of the regression).
Second, a maximum correlation portfolio only implies the constraint of
being maximum correlated to the factor of interest. It does not imply a
restriction on the correlation to other factors. Therefore, the inherent risk
premium of a maximum correlation portfolio may substantially dier from
the market price of risk of the true factor of interest, due to potential
correlation to other economic factors.
However, the product of the factor risk premium (
) and the estimated

beta (
f
) with respect to the factor mimicking portfolio are proportional
to the true factor (
f
) and the respective MPR (), i.e.
f
=

Unit-Beta Portfolios
The issue is somehow resolved by the construction of a unit beta
portfolio, which are formed on the additional constraint to have a beta of
one with respect to the factor of interest and zero to all other factors.
Conceptually, the (true) market price of risk is the expected value of
the excess return on a unit-beta portfolio.
However, the additional restrictions require full knowledge of all
pricing-relevant factors, which is empirically questionable.
Further, an important property of the weights of a unit beta portfolio is
demonstrated by Balduzzi and Robboti (2008), who show that the so
constructed weights are equal to the weights obtained from the
cross-sectional approach.
Thus, unit-beta portfolios do not provide any empirical advantages.
Unit-Beta Portfolios
We will look at the concept of mimicking portfolios in much more detail
in one of the upcoming lectures...
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Advanced Asset Pricing

Factor Pricing and Beta Models

is the N 1 vector of regression intercepts.

is the covariance matrix of the residuals, i.e. the sample estimate of

) and the estimated

Dr. des. Matthias Huss Universitt Basel - WWZ - Abteilung fr Finanzmarkttheorie

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