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Which (Nonlinear) Factor Models?

Author

Listed:
  • Caio Almeida

    (Princeton University)

  • Gustavo Freire

    (Erasmus University Rotterdam)

Abstract

Traditional asset pricing tests boil down to evaluating the maximum Sharpe ratio obtained from the factors in a given model. This implicitly assumes the linear stochastic discount factor (SDF) that prices the factors as the asset pricing model. We generalize this approach by considering a comprehensive family of nonlinear SDFs pricing the model factors. The relevant metric for model comparison becomes the maximum Sharpe ratio of the mimicking portfolio constructed by projecting the nonlinear SDF onto the test assets. We show that nonlinearities matter empirically for both absolute and relative pricing performance of leading factor models.

Suggested Citation

  • Caio Almeida & Gustavo Freire, 2023. "Which (Nonlinear) Factor Models?," Working Papers 2023-07, Princeton University. Economics Department..
    • Handle: RePEc:pri:econom:2023-07
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    More about this item

    Keywords

    Model Comparison; Factor Models; Anomalies; Stochastic Discount Factor; Nonlinearities;
    All these keywords.

    JEL classification:

    • C52 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Model Evaluation, Validation, and Selection
    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates

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