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Semiparametric Conditional Factor Models in Asset Pricing

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  • Qihui Chen
  • Nikolai Roussanov
  • Xiaoliang Wang

Abstract

We introduce a simple and tractable methodology for estimating semiparametric conditional latent factor models. Our approach disentangles the roles of characteristics in capturing factor betas of asset returns from ``alpha.'' We construct factors by extracting principal components from Fama-MacBeth managed portfolios. Applying this methodology to the cross-section of U.S. individual stock returns, we find compelling evidence of substantial nonzero pricing errors, even though our factors demonstrate superior performance in standard asset pricing tests. Unexplained ``arbitrage'' portfolios earn high Sharpe ratios, which decline over time. Combining factors with these orthogonal portfolios produces out-of-sample Sharpe ratios exceeding 4.

Suggested Citation

  • Qihui Chen & Nikolai Roussanov & Xiaoliang Wang, 2021. "Semiparametric Conditional Factor Models in Asset Pricing," Papers 2112.07121, arXiv.org, revised Apr 2025.
  • Handle: RePEc:arx:papers:2112.07121
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    References listed on IDEAS

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    1. Luyang Chen & Markus Pelger & Jason Zhu, 2024. "Deep Learning in Asset Pricing," Management Science, INFORMS, vol. 70(2), pages 714-750, February.
    2. Qihui Chen & Zheng Fang, 2018. "Improved Inference on the Rank of a Matrix," Papers 1812.02337, arXiv.org, revised Mar 2019.
    3. Jushan Bai & Serena Ng, 2002. "Determining the Number of Factors in Approximate Factor Models," Econometrica, Econometric Society, vol. 70(1), pages 191-221, January.
    4. Belloni, Alexandre & Chernozhukov, Victor & Chetverikov, Denis & Kato, Kengo, 2015. "Some new asymptotic theory for least squares series: Pointwise and uniform results," Journal of Econometrics, Elsevier, vol. 186(2), pages 345-366.
    5. Qihui Chen & Zheng Fang, 2019. "Improved inference on the rank of a matrix," Quantitative Economics, Econometric Society, vol. 10(4), pages 1787-1824, November.
    6. Chamberlain, Gary & Rothschild, Michael, 1983. "Arbitrage, Factor Structure, and Mean-Variance Analysis on Large Asset Markets," Econometrica, Econometric Society, vol. 51(5), pages 1281-1304, September.
    7. Chen, Xiaohong, 2007. "Large Sample Sieve Estimation of Semi-Nonparametric Models," Handbook of Econometrics, in: J.J. Heckman & E.E. Leamer (ed.), Handbook of Econometrics, edition 1, volume 6, chapter 76, Elsevier.
    8. John H. Cochrane, 2011. "Presidential Address: Discount Rates," Journal of Finance, American Finance Association, vol. 66(4), pages 1047-1108, August.
    9. Seung C. Ahn & Alex R. Horenstein, 2013. "Eigenvalue Ratio Test for the Number of Factors," Econometrica, Econometric Society, vol. 81(3), pages 1203-1227, May.
    10. Jushan Bai, 2003. "Inferential Theory for Factor Models of Large Dimensions," Econometrica, Econometric Society, vol. 71(1), pages 135-171, January.
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    Cited by:

    1. Qihui Chen, 2022. "Robust Estimation of Conditional Factor Models," Papers 2204.00801, arXiv.org, revised Apr 2022.
    2. Alain-Philippe Fortin & Patrick Gagliardini & Olivier Scaillet, 2022. "Eigenvalue tests for the number of latent factors in short panels," Papers 2210.16042, arXiv.org.

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