Please use this identifier to cite or link to this item: https://hdl.handle.net/10419/318175 
Year of Publication: 
2021
Series/Report no.: 
BCAM Working Paper No. 2108
Publisher: 
Birkbeck, University of London, Birkbeck Centre for Applied Macroeconomics (BCAM), London
Abstract: 
The arbitrage pricing theory (APT) attributes differences in expected returns to exposure to systematic risk factors. Two aspects of the APT are considered. Firstly, the factors in the statistical asset pricing model are related to a theoretically consistent set of factors defined by their conditional covariation with the stochastic discount factor (SDF) used to price securities within inter-temporal asset pricing models. It is shown that risk premia arise from non-zero correlation of observed factors with SDF and the pricing errors arise from the correlation of the errors in the statistical model with SDF. Secondly, the estimates of factor risk premia using portfolios are compared to those obtained using individual securities. It is shown that in the presence of pricing errors consistent estimation of risk premia requires a large number of not fully diversified portfolios. Also, in general, it is not possible to rank estimators using individual securities and portfolios in terms of their small sample bias.
Subjects: 
Arbitrage Pricing Theory
Stochastic Discount Factor
portfolios
factor strength
identification of risk premia
two-pass regressions
Fama-MacBeth
JEL: 
C38
G12
Document Type: 
Working Paper

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