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Asset Pricing Models: Implications for Expected Returns and Portfolio Selection

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  • A. CRAIG MacKINLAY
  • LUBOŠ PÁSTOR

Abstract

When a risk factor is missing from an asset pricing model, the resulting mispricing is embedded within the residual covariance matrix. Exploiting this phenomenon leads to expected return estimates that are more stable and precise than estimates delivered by standard methods. Portfolio selection can also be improved. At an extreme, optimal portfolio weights are proportional to expected returns when no factors are observable. We find that such portfolios perform well in simulations and in out-of-sample comparisons. Article published by Oxford University Press on behalf of the Society for Financial Studies in its journal, The Review of Financial Studies.

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Paper provided by Center for Research in Security Prices, Graduate School of Business, University of Chicago in its series CRSP working papers with number 510.

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Handle: RePEc:wop:chispw:510

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  1. Dickinson, J. P., 1974. "The Reliability of Estimation Procedures in Portfolio Analysis," Journal of Financial and Quantitative Analysis, Cambridge University Press, Cambridge University Press, vol. 9(03), pages 447-462, June.
  2. Huberman, Gur & Kandel, Shmuel & Stambaugh, Robert F, 1987. " Mimicking Portfolios and Exact Arbitrage Pricing," Journal of Finance, American Finance Association, American Finance Association, vol. 42(1), pages 1-9, March.
  3. Huberman, Gur & Kandel, Shmuel, 1987. " Mean-Variance Spanning," Journal of Finance, American Finance Association, American Finance Association, vol. 42(4), pages 873-88, September.
  4. Jorion, Philippe, 1986. "Bayes-Stein Estimation for Portfolio Analysis," Journal of Financial and Quantitative Analysis, Cambridge University Press, Cambridge University Press, vol. 21(03), pages 279-292, September.
  5. Josef Lakonishok & Andrei Shleifer & Robert W. Vishny, 1993. "Contrarian Investment, Extrapolation, and Risk," University of Chicago - George G. Stigler Center for Study of Economy and State, Chicago - Center for Study of Economy and State 84, Chicago - Center for Study of Economy and State.
  6. Grinblatt, Mark & Titman, Sheridan, 1987. "The Relation between Mean-Variance Efficiency and Arbitrage Pricing," The Journal of Business, University of Chicago Press, vol. 60(1), pages 97-112, January.
  7. Lubos Pástor & Robert F. Stambaugh, . "Costs of Equity Capital and Model Mispricing," Rodney L. White Center for Financial Research Working Papers, Wharton School Rodney L. White Center for Financial Research 04-98, Wharton School Rodney L. White Center for Financial Research.
  8. Kent Daniel & Sheridan Titman, 1996. "Evidence on the Characteristics of Cross Sectional Variation in Stock Returns," NBER Working Papers 5604, National Bureau of Economic Research, Inc.
  9. Green, R.C. & Hollifield, B., 1990. "When Will Mean-Variance Efficient Portfolios Be Well Diversified?," GSIA Working Papers, Carnegie Mellon University, Tepper School of Business 1990-12, Carnegie Mellon University, Tepper School of Business.
  10. Gibbons, Michael R & Ross, Stephen A & Shanken, Jay, 1989. "A Test of the Efficiency of a Given Portfolio," Econometrica, Econometric Society, Econometric Society, vol. 57(5), pages 1121-52, September.
  11. Jorion, Philippe, 1991. "Bayesian and CAPM estimators of the means: Implications for portfolio selection," Journal of Banking & Finance, Elsevier, Elsevier, vol. 15(3), pages 717-727, June.
  12. Connor, Gregory & Korajczyk, Robert A., 1986. "Performance measurement with the arbitrage pricing theory : A new framework for analysis," Journal of Financial Economics, Elsevier, Elsevier, vol. 15(3), pages 373-394, March.
  13. 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.
  14. Roll, Richard & Ross, Stephen A, 1980. " An Empirical Investigation of the Arbitrage Pricing Theory," Journal of Finance, American Finance Association, American Finance Association, vol. 35(5), pages 1073-1103, December.
  15. Ross, Stephen A., 1976. "The arbitrage theory of capital asset pricing," Journal of Economic Theory, Elsevier, Elsevier, vol. 13(3), pages 341-360, December.
  16. repec:fth:pennfi:72 is not listed on IDEAS
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