Citation

Discussion Paper Details

Please find the details for DP12926 in an easy to copy and paste format below:

Full Details

Title: Estimating Latent Asset-Pricing Factors

Author(s): Martin Lettau and Markus Pelger

Publication Date: May 2018

Keyword(s): Anomalies, Cross Section of Returns, expected returns, high-dimensional data, Latent Factors, PCA and Weak Factors

Programme Area(s): Financial Economics

Abstract: We develop an estimator for latent factors in a large-dimensional panel of financial data that can explain expected excess returns. Statistical factor analysis based on Principal Component Analysis (PCA) has problems identifying factors with a small variance that are important for asset pricing. We generalize PCA with a penalty term accounting for the pricing error in expected returns. Our estimator searches for factors that can explain both the expected return and covariance structure. We derive the statistical properties of the new estimator and show that our estimator can find asset-pricing factors, which cannot be detected with PCA, even if a large amount of data is available. Applying the approach to portfolio data we find factors with Sharpe-ratios more than twice as large as those based on conventional PCA and with significantly smaller pricing errors.

For full details and related downloads, please visit: https://cepr.org/active/publications/discussion_papers/dp.php?dpno=12926

Bibliographic Reference

Lettau, M and Pelger, M. 2018. 'Estimating Latent Asset-Pricing Factors'. London, Centre for Economic Policy Research. https://cepr.org/active/publications/discussion_papers/dp.php?dpno=12926