Serhiy Kozak (Maryland): When do cross-sectional asset pricing factors span the stochastic discount factor?
Presenter: Serhiy Kozak (Maryland)
Discussant: Kerry Back (Rice)
Zoom webinar link:
Webinar ID: 995 2761 7447
When do cross-sectional asset pricing factors span the stochastic discount factor?
Authors: Serhiy Kozak and Stefan Nagel
Abstract:When expected returns are linear in asset characteristics, the stochastic discount factor (SDF) that prices individual stocks can be represented as a factor model with GLS cross-sectional regression slope factors. Factors constructed heuristically by aggregating individual stocks into characteristics-based factor portfolios using sorting, characteristics-weighting, or OLS cross-sectional regression slopes do not span this SDF unless the covariance matrix of stock returns has a specific structure. These conditions are more likely satisfied when researchers use large numbers of characteristics simultaneously. Methods to hedge unpriced components of heuristic factor returns allow partial relaxation of these conditions. We also show the conditions that must hold for dimension reduction to a number of factors smaller than the number of characteristics to be possible without having to invert a large covariance matrix. Under these conditions, instrumented and projected principal components analysis methods can be implemented as simple PCA on certain portfolio sorts.
Bio of speaker:
Serhiy Kozak is an assistant professor of finance at the Robert H. Smith School of Business at the University of Maryland. Prior to that, he was an assistant professor of finance at the University of Michigan, Ross School of Business. His current research focuses on embedding economic and asset pricing restrictions into machine learning methods to study the dynamics of asset prices. Serhiy earned his PhD at the University of Chicago in 2013.
Bio of discussant:
Kerry Back is the J. Howard Creekmore Professor of Finance and Professor of Economics in the Jones Graduate School of Business and a Professor of Economics in the School of Social Sciences at Rice University. He previously served on the faculties of Northwestern University, Indiana University, Washington University in St. Louis, and Texas A&M University. He currently teaches asset pricing theory to PhD students in the Jones School and the Department of Economics, fundamentals of finance and quantitative finance to students in the Masters of Data Science program in the Department of Computer Science, and machine learning in finance and quantitative investment strategies to MBA students in the Jones School. He is a former editor of the Review of Financial Studies, a former editor of Finance & Stochastics, and a former associate editor of the Journal of Finance and various other academic journals. He is the author of two textbooks and of numerous articles in the leading finance and economics journals.
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