Factor Models with Downside Risk
128 Pages Posted: 11 Oct 2021 Last revised: 28 Dec 2023
Date Written: October 6, 2021
Abstract
We propose a conditional model of asset returns in the presence of common factors and downside risk. Specifically, we generalize existing latent factor models in three ways: we show how to estimate the threshold which identifies the “disappointment” event triggering the bad state of the world; we permit different factor structures for asset returns in good and bad states; we show how to estimate consistently the conditional risk premia of observable factors from the estimated latent factors. The usefulness of the model is illustrated with an application to a broad cross-section of stock returns in- and out-of-sample.
Keywords: factor models, downside risk, risk premium, conditional asset pricing
JEL Classification: G12, G15, C12, C31, C32
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