DP12463 Shrinking the Cross Section

Author(s): Serhiy Kozak, Stefan Nagel, Shrihari Santosh
Publication Date: November 2017
Programme Areas: Financial Economics
Link to this Page: www.cepr.org/active/publications/discussion_papers/dp.php?dpno=12463

We construct a robust stochastic discount factor (SDF) that summarizes the joint explanatory power of a large number of cross-sectional stock return predictors. Our method achieves robust out-of-sample performance in this high-dimensional setting by imposing an economically motivated prior on SDF coefficients that shrinks the contributions of low-variance principal components of the candidate factors. While empirical asset pricing research has focused on SDFs with a small number of characteristics-based factors-e.g., the four- or five-factor models discussed in the recent literature-we find that such a characteristics-sparse SDF cannot adequately summarize the cross-section of expected stock returns. However, a relatively small number of principal components of the universe of potential characteristics-based factors can approximate the SDF quite well.