A Conditional Asset Pricing Model with the Optimal Orthogonal Portfolio

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Abstract

This paper employs a conditional asset-pricing model based on the optimal orthogonal portfolio approach to construct a factor portfolio that embodies all the latent factors important for pricing a given set of test assets. The advantage of this portfolio to the anomaly related mimicking portfolios is its ability to separate out the components of average return that are not related to the return covariation. The performance of this portfolio is evaluated against several conventional factors, using both cross-sectional and time-series regression approaches, as well as the Hansen and Jagannathan (1997) distance measure. Its strong out-of-sample results indicate that our suggested methodology may have important applications in risk management, portfolio selection and performance evaluation.

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Research areas and keywords

Subject classification (UKÄ) – MANDATORY

  • Economics

Keywords

  • Optimal orthogonal portfolio, Factor pricing, Time-varying risk premium
Original languageEnglish
Pages (from-to)1027-1040
JournalJournal of Banking & Finance
Volume35
Issue number5
Publication statusPublished - 2011
Publication categoryResearch
Peer-reviewedYes