Paolo Zaffaroni (Imperial College London): Cross-Sectional Asset Pricing with Unsystematic Risk

Paolo Zaffaroni (Imperial College London): Cross-Sectional Asset Pricing with Unsystematic Risk

Authors: Massimo Dello Preite, Raman Uppal, Paolo Zaffaroni, Irina Zviadadze

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.

Bio: Paolo Zaffaroni is Professor in Financial Econometrics at Imperial College Business School. Paolo's main research interests are empirical asset pricing, portfolio choice, financial econometrics and econometric theory. His publications include the Annals of Statistics, the Journal of Monetary Economics, the Review of Financial Studies and the Journal of Econometrics. Paolo has been elected a Fellow of the Journal of Econometrics. He holds a PhD in Econometrics from the London School of Economics. He is also teaching at the University of Rome La Sapienza and has previously taught at the London School of Economics and at the University of Cambridge. Paolo acts as quantitative consultant in asset and risk management and as instructor of executive courses for various financial institutions.