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Asset Pricing with Unsystematic Risk

  • Location
    Erasmus University Rotterdam, E building, room ET-18
  • Date and time

    November 02, 2023
    12:00 - 13:00


Our objective is to price the cross-section of asset returns. Despite considering hundreds of systematic risk factors (``factor zoo''), factor models still have sizable pricing errors. A limitation of these models is that expected excess returns compensate only for systematic risk. We also allow compensation for unsystematic risk while imposing no arbitrage. The resulting stochastic discount factor (SDF) dominates traditional factor models in pricing assets. Empirically, about 70% of this SDF's variation is explained by its unsystematic-risk component, which is correlated with strategies reflecting market frictions and behavioral biases. Our findings provide an avenue for resolving the factor zoo.