Linear Factor Models and the Estimation of Expected Returns

RePEc Short ID: pwe126
ORCID iD: 0000-0001-9007-0755

Sarisoy, Cisil; Werker, Bas J.M.

doi:10.17016/FEDS.2024.014

Working Paper

Linear Factor Models and the Estimation of Expected Returns

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;

JEL Classification: C13; G11; C38;

https://doi.org/10.17016/FEDS.2024.014