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| Main Authors: | , |
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| Format: | Preprint |
| Published: |
2024
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| Online Access: | https://arxiv.org/abs/2405.10920 |
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| _version_ | 1866917669129682944 |
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| author | Guo, Shuxin Liu, Qiang |
| author_facet | Guo, Shuxin Liu, Qiang |
| contents | We study the data-generating processes for factors expressed in return differences, which the literature on time-series asset pricing seems to have overlooked. For the factors' data-generating processes or long-short zero-cost portfolios, a meaningful definition of returns is impossible; further, the compounded market factor (MF) significantly underestimates the return difference between the market and the risk-free rate compounded separately. Surprisingly, if MF were treated coercively as periodic-rebalancing long-short (i.e., the same as size and value), Fama-French three-factor (FF3) would be economically unattractive for lacking compounding and irrelevant for suffering from the small "size of an effect." Otherwise, FF3 might be misspecified if MF were buy-and-hold long-short. Finally, we show that OLS with net returns for single-index models leads to inflated alphas, exaggerated t-values, and overestimated Sharpe ratios (SR); worse, net returns may lead to pathological alphas and SRs. We propose defining factors (and SRs) with non-difference compound returns. |
| format | Preprint |
| id |
arxiv_https___arxiv_org_abs_2405_10920 |
| institution | arXiv |
| publishDate | 2024 |
| record_format | arxiv |
| spellingShingle | Data-generating process and time-series asset pricing Guo, Shuxin Liu, Qiang General Finance Portfolio Management Risk Management We study the data-generating processes for factors expressed in return differences, which the literature on time-series asset pricing seems to have overlooked. For the factors' data-generating processes or long-short zero-cost portfolios, a meaningful definition of returns is impossible; further, the compounded market factor (MF) significantly underestimates the return difference between the market and the risk-free rate compounded separately. Surprisingly, if MF were treated coercively as periodic-rebalancing long-short (i.e., the same as size and value), Fama-French three-factor (FF3) would be economically unattractive for lacking compounding and irrelevant for suffering from the small "size of an effect." Otherwise, FF3 might be misspecified if MF were buy-and-hold long-short. Finally, we show that OLS with net returns for single-index models leads to inflated alphas, exaggerated t-values, and overestimated Sharpe ratios (SR); worse, net returns may lead to pathological alphas and SRs. We propose defining factors (and SRs) with non-difference compound returns. |
| title | Data-generating process and time-series asset pricing |
| topic | General Finance Portfolio Management Risk Management |
| url | https://arxiv.org/abs/2405.10920 |