Evaluating the effectiveness of Common-Factor Portfolios

Carrasco Gutierrez, Carlos Enrique and Issler, João Victor (2015): Evaluating the effectiveness of Common-Factor Portfolios.

Abstract

In this paper we use the standard factor models to compose common-factor portfolios by a novel linear transformation extracted from large data sets of asset returns. Although the transformation proposed here retains the basic properties of the usual common factors, some interesting new properties are further included in them. The advantages of using common-factor portfolios in asset pricing are: (i) they produce a dimension reduction in the asset- pricing data-base while preserving the usual restrictions imposed by the asset-pricing equation, and (ii) from the empirical perspective, their performance is better than those of standard factor models. The practical importance is confirmed in two applications: the performance of common-factor portfolios is shown to be superior to those of the asset returns and factors commonly used in the finance literature.

• Item Type: MPRA Paper
• Language: English
• Keywords: Common Factors, Common Features, CCAPM, Stochastic Discount Factor, Linear Multifactor Model.
• Subjects: C - Mathematical and Quantitative Methods > C3 - Multiple or Simultaneous Equation Models ; Multiple Variables > C32 - Time-Series Models ; Dynamic Quantile Regressions ; Dynamic Treatment Effect Models ; Diffusion Processes ; State Space Models; E - Macroeconomics and Monetary Economics > E2 - Consumption, Saving, Production, Investment, Labor Markets, and Informal Economy > E21 - Consumption ; Saving ; Wealth; E - Macroeconomics and Monetary Economics > E4 - Money and Interest Rates > E44 - Financial Markets and the Macroeconomy; G - Financial Economics > G1 - General Financial Markets > G12 - Asset Pricing ; Trading Volume ; Bond Interest Rates

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