Factor Models with Downside Risk

128 Pages Posted: 11 Oct 2021 Last revised: 28 Dec 2023

See all articles by Daniele Massacci

Daniele Massacci

King's College London; University of Naples Federico II; CSEF - University of Naples Federico II - Centre for Studies in Economics and Finance (CSEF)

Lucio Sarno

University of Cambridge - Judge Business School; Centre for Economic Policy Research (CEPR)

Lorenzo Trapani

University of Leicester - School of Business; University of Pavia - Department of Economics and Business Sciences

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

Suggested Citation

Massacci, Daniele and Sarno, Lucio and Trapani, Lorenzo, Factor Models with Downside Risk (October 6, 2021). Available at SSRN: https://ssrn.com/abstract=3937321 or http://dx.doi.org/10.2139/ssrn.3937321

Daniele Massacci

King's College London ( email )

United Kingdom

University of Naples Federico II ( email )

Naples, Naples
Italy

CSEF - University of Naples Federico II - Centre for Studies in Economics and Finance (CSEF) ( email )

Via Cintia
Complesso Monte S. Angelo
Naples, Naples 80126
Italy

Lucio Sarno (Contact Author)

University of Cambridge - Judge Business School ( email )

Trumpington Street
Cambridge, CB2 1AG
United Kingdom

Centre for Economic Policy Research (CEPR)

London
United Kingdom

Lorenzo Trapani

University of Leicester - School of Business ( email )

University of Leicester Business School
University Road
Leicester, Leicestershire LE1 7RH
United Kingdom

University of Pavia - Department of Economics and Business Sciences ( email )

Corso Strada Nuova, 65
Pavia, +39 0382 984402 27100
Italy

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