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Covariances versus Characteristics in General Equilibrium

  • Xiaoji Lin
  • Lu Zhang

We question a deep-ingrained doctrine in asset pricing: If an empirical characteristic-return relation is consistent with investor "rationality," the relation must be "explained" by a risk factor model. The investment approach changes the big picture of asset pricing. Factors formed on characteristics are not necessarily risk factors: Characteristics-based factor models are linear approximations of firm-level investment returns. The evidence that characteristics dominate covariances in horse races does not necessarily mean mispricing: Measurement errors in covariances are more likely to blame. Most important, the investment approach completes the consumption approach in general equilibrium, especially for cross-sectional asset pricing.

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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 17285.

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Date of creation: Aug 2011
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Handle: RePEc:nbr:nberwo:17285
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