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Constructing Common-Factor Portfolios

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  • Carrasco-Gutierrez, Carlos Enrique
  • Issler, João Victor

Abstract

In this paper we construct common-factor portfolios using a novel linear transformation of standardfactor models extracted from large data sets of asset returns. The simple transformation proposed herekeeps the basic properties of the usual factor transformations, although some new interesting propertiesare further attached to them. Some theoretical advantages are shown to be present. Also, their practicalimportance is confi rmed in two applications: the performance of common-factor portfolios are shown tobe superior to that of asset returns and factors commonly employed in the finance literature.

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Paper provided by FGV/EPGE Escola Brasileira de Economia e Finanças, Getulio Vargas Foundation (Brazil) in its series Economics Working Papers (Ensaios Economicos da EPGE) with number 731.

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Date of creation: 19 Apr 2012
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Handle: RePEc:fgv:epgewp:731

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  1. Mario Forni & Marc Hallin & Lucrezia Reichlin & Marco Lippi, 2000. "The generalised dynamic factor model: identification and estimation," ULB Institutional Repository 2013/10143, ULB -- Universite Libre de Bruxelles.
  2. Lars Peter Hansen & Ravi Jagannathan, 1990. "Implications of security market data for models of dynamic economies," Discussion Paper / Institute for Empirical Macroeconomics, Federal Reserve Bank of Minneapolis 29, Federal Reserve Bank of Minneapolis.
  3. Ross, Stephen A., 1976. "The arbitrage theory of capital asset pricing," Journal of Economic Theory, Elsevier, Elsevier, vol. 13(3), pages 341-360, December.
  4. Fama, Eugene F. & French, Kenneth R., 1993. "Common risk factors in the returns on stocks and bonds," Journal of Financial Economics, Elsevier, Elsevier, vol. 33(1), pages 3-56, February.
  5. Harrison, J. Michael & Kreps, David M., 1979. "Martingales and arbitrage in multiperiod securities markets," Journal of Economic Theory, Elsevier, Elsevier, vol. 20(3), pages 381-408, June.
  6. Breeden, Douglas T., 1979. "An intertemporal asset pricing model with stochastic consumption and investment opportunities," Journal of Financial Economics, Elsevier, Elsevier, vol. 7(3), pages 265-296, September.
  7. Fama, Eugene F & French, Kenneth R, 1992. " The Cross-Section of Expected Stock Returns," Journal of Finance, American Finance Association, American Finance Association, vol. 47(2), pages 427-65, June.
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