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Bayesian Variable Selection of Risk Factors in the APT Model

Author

Listed:
  • Robert Kohn

    () (School of Economics, The University of New South Wales)

  • Rachida Ouysse

    () (School of Economics, The University of New South Wales)

Abstract

In this paper we use a probabilistic approach to risk factor selection in the arbitrage pricing theory model. The methodology uses a bayesian framework to simultaneously select the pervasive risk factors and estimate the model. This will enable correct inference and testing of the implications of the APT model. Furthermore, we are able to make inference on any function of the parameters, in particular the pricing errors. We can also carry out tests of efficiency of the APT using the posterior odds ratio and bayesian confidence intervals. We investigate the macroeconomic risk factors of Chen, Roll, and Ross (1986) and the firm characteristic factors of Fama and French (1992,1993). Using monthly portfolio returns grouped by size and book to market, we find that the economic variables have zero risk premia although some appear to have non zero posterior probability. The "Market" factor is not priced. An APT model with factors mimicking size (SMB), book to market equity (HML), value-weighted portfolio and Standard and Poor, is supported by a conditionally independent prior and offers a significant decrease in the pricing error over a two-factor APT with SMB and HML. The posterior probability and cumulative distributions functions of the average risk premia and the pricing errors are compared to the normal distribution. The results show that under certain conditions the distortions are very small.

Suggested Citation

  • Robert Kohn & Rachida Ouysse, 2007. "Bayesian Variable Selection of Risk Factors in the APT Model," Discussion Papers 2007-32, School of Economics, The University of New South Wales.
    • Handle: RePEc:swe:wpaper:2007-32
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    File URL: http://wwwdocs.fce.unsw.edu.au/economics/Research/WorkingPapers/2007_32.pdf
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    References listed on IDEAS

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    1. Geweke, John & Zhou, Guofu, 1996. "Measuring the Pricing Error of the Arbitrage Pricing Theory," Review of Financial Studies, Society for Financial Studies, vol. 9(2), pages 557-587.
    2. Ferson, Wayne E & Harvey, Campbell R, 1991. "The Variation of Economic Risk Premiums," Journal of Political Economy, University of Chicago Press, vol. 99(2), pages 385-415, April.
    3. Ouysse, Rachida, 2006. "Consistent variable selection in large panels when factors are observable," Journal of Multivariate Analysis, Elsevier, vol. 97(4), pages 946-984, April.
    4. Smith, Michael & Kohn, Robert, 1996. "Nonparametric regression using Bayesian variable selection," Journal of Econometrics, Elsevier, vol. 75(2), pages 317-343, December.
    5. Chen, Nai-Fu & Roll, Richard & Ross, Stephen A, 1986. "Economic Forces and the Stock Market," The Journal of Business, University of Chicago Press, vol. 59(3), pages 383-403, July.
    6. Smith M. & Kohn R., 2002. "Parsimonious Covariance Matrix Estimation for Longitudinal Data," Journal of the American Statistical Association, American Statistical Association, vol. 97, pages 1141-1153, December.
    7. Burmeister, Edwin & McElroy, Marjorie B, 1988. " Joint Estimation of Factor Sensitivities and Risk Premia for the Arbitrage Pricing Theory," Journal of Finance, American Finance Association, vol. 43(3), pages 721-733, July.
    8. Fama, Eugene F. & French, Kenneth R., 1993. "Common risk factors in the returns on stocks and bonds," Journal of Financial Economics, Elsevier, vol. 33(1), pages 3-56, February.
    9. Liang, Feng & Paulo, Rui & Molina, German & Clyde, Merlise A. & Berger, Jim O., 2008. "Mixtures of g Priors for Bayesian Variable Selection," Journal of the American Statistical Association, American Statistical Association, vol. 103, pages 410-423, March.
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    Cited by:

    1. Rachida Ouysse & Chris Nicholas, 2008. "Time Varying Determinants of Cross-Country Growth," Discussion Papers 2008-03, School of Economics, The University of New South Wales.

    More about this item

    Keywords

    Variable selection; Posterior density; Bayes factors; MCMC; APT models;

    JEL classification:

    • C1 - Mathematical and Quantitative Methods - - Econometric and Statistical Methods and Methodology: General
    • C22 - Mathematical and Quantitative Methods - - Single Equation Models; Single Variables - - - Time-Series Models; Dynamic Quantile Regressions; Dynamic Treatment Effect Models; Diffusion Processes
    • C52 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Model Evaluation, Validation, and Selection

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