Cross-sectional Asset Pricing with Unsystematic Risk
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SeriesErasmus Finance Seminars
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Speaker(s)Irina Zviadadze (HEC Paris, France)
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FieldFinance, Accounting and Finance
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LocationErasmus University Rotterdam, T03-35
Rotterdam -
Date and time
April 09, 2024
11:45 - 13:00
Abstract
Our objective is to price the cross-section of asset returns. In contrast to existing models that allow expected excess returns to reflect compensation only for systematic risk, we derive a stochastic discount factor (SDF) implied by the Arbitrage Pricing Theory and consistent with the equilibrium model of Merton (1987), in which there is compensation also for unsystematic risk. Empirically, we find that more than seventy percent of this SDF’s variation is explained by unsystematic risk. Our SDF dominates traditional factor models and the state-of-the-art models of latent systematic risk in pricing the cross-section of asset returns in and out of sample.