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Asset Pricing with Unsystematic Risk

  • Location
    Tinbergen Institute Amsterdam, room 1.01
  • Date and time

    December 06, 2023
    12:45 - 14:00

We revise the conventional risk-return tradeoff that is exclusively based on systematic risk. We derive the stochastic discount factor (SDF) implied by the arbitrage-pricing theory, in which we explicitly allow compensation also for unsystematic risk while preserving no arbitrage. Empirically, we find that about 70% of this SDF's variation is explained by its unsystematic-risk component. Our SDF dominates traditional factor models and the state-of-the-art models of latent systematic risk in pricing a cross-section of assets in and out of sample. We outline an example of an equilibrium theory consistent with nonzero compensation for unsystematic risk and the specification of our SDF.