Tuesday, November 22, 2011

Falkenstein on Risk Premium

The idea that there exist risk premiums based on covariances with unidentified stochastic discount factors that are like the S&P500 return, but orthogonal to it, will be in the trash heap of bad ideas. As no one can articulate what such a factor might be, it seems absurd that millions of people are implicitly valuing companies, currencies, and futures this way.

Posted by CP at 10:12 PM

1 comment:

WSM said...

The comment posted there was also good:

"Anonymous said...

There is nothing mysterious, circuitous or amusing in the way Axioma build the low vol ETF. It would have been very easy to pick the lowest vol stocks for R1000 and build an ETF off them. There are two problems with this approach. First it ignores transaction costs; second, the portfolio may have significant exposures to other factors. What Axioma does is take a low-vol portfolio (not unlike SPLV), and then replicates its vol characteristics taking into account transaction costs (the 200 stock limit is arguably part of this approach) and neutralizing exposures to predicted beta and momentum. There is nothing magic to this. Most definitely it is not, as you write in the end, done by having non-zero factor exposure to vol factor. In this respect you and Axioma seem to agree.

Moreover, your estimates of beta and vol are historical. This is OK as a first approximation, but if you use more accurate *predicted* vols and betas from commercial risk models, you'll get closer results: 20% and 22% for vols (annualized), and .69 and .81 for betas. The reason for the worse beta is that short-term momentum has negative beta, and by being neutral to it the resulting portfolio must have higher beta.

I also have to disagree with your interpretation of Daniel and Titman. Certainly their paper fundamentally criticized the Fama-McBeth approach to factor model construction, but is compatible with fundamental risk models and factor models in general. In the former, the characteristic does have an interpretation as an approximate beta of the (estimated) factor with with a stock."

November 23, 2011 at 7:38 AM

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