What is Missing in Asset-Pricing Factor Models?
Our objective is to develop a methodology to price the cross section of asset returns. Despite the hundreds of systematic risk factors considered in the literature (“factor zoo”), there is still a sizable pricing error. Our key insight is that the pricing error is compensation not just for omitted systematic risk but also asset-specific risk. We use this insight to construct a stochastic discount factor (SDF) that prices the cross section of stock returns exactly, and therefore, resolves the factor zoo. Empirically, we demonstrate that more than half of the variation in this SDF is explained by an aggregate measure of asset-specific risk that reflects market frictions and behavioral biases.
- Informed public