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Evaluating the Importance of Missing Risk Factors Using the Optimal Orthogonal Portfolio Approach

Asgharian, Hossein LU and Hansson, Björn LU (2005) In Journal of Empirical Finance 12(4). p.556-575
Abstract
We apply the orthogonal portfolio approach to analyse the importance of risk factors potentially missing from the CAPM. We generalize the approach proposed by MacKinlay and Pastor (2000) [MacKinlay, A.C., Pastor, L., 2000. Asset pricing models: implications for expected returns and portfolio selection. Review of Financial Studies 13, 883–916] by estimating the Sharpe ratio of the optimal orthogonal portfolio. Our result, based on US industry portfolios for the period 1927–2002, reveals important risk factors missing from the CAPM during periods with high market volatility. We show that a priori fixing the Sharpe ratio, which is an assumption used by MacKinlay and Pastor (2000) [MacKinlay, A.C., Pastor, L., 2000. Asset pricing models:... (More)
We apply the orthogonal portfolio approach to analyse the importance of risk factors potentially missing from the CAPM. We generalize the approach proposed by MacKinlay and Pastor (2000) [MacKinlay, A.C., Pastor, L., 2000. Asset pricing models: implications for expected returns and portfolio selection. Review of Financial Studies 13, 883–916] by estimating the Sharpe ratio of the optimal orthogonal portfolio. Our result, based on US industry portfolios for the period 1927–2002, reveals important risk factors missing from the CAPM during periods with high market volatility. We show that a priori fixing the Sharpe ratio, which is an assumption used by MacKinlay and Pastor (2000) [MacKinlay, A.C., Pastor, L., 2000. Asset pricing models: implications for expected returns and portfolio selection. Review of Financial Studies 13, 883–916], may produce less plausible estimates of the expected returns. (Less)
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author
organization
publishing date
type
Contribution to journal
publication status
published
subject
keywords
Investment strategy, Orthogonal portfolio, Simulated annealing, Factor pricing
in
Journal of Empirical Finance
volume
12
issue
4
pages
556 - 575
publisher
North-Holland
external identifiers
  • scopus:26844566285
ISSN
0927-5398
DOI
10.1016/j.jempfin.2004.09.002
language
English
LU publication?
yes
id
0fb10fbb-f9dd-4f21-86b1-e7345ab67106 (old id 1384548)
date added to LUP
2009-04-20 12:27:13
date last changed
2017-01-01 07:04:15
@article{0fb10fbb-f9dd-4f21-86b1-e7345ab67106,
  abstract     = {We apply the orthogonal portfolio approach to analyse the importance of risk factors potentially missing from the CAPM. We generalize the approach proposed by MacKinlay and Pastor (2000) [MacKinlay, A.C., Pastor, L., 2000. Asset pricing models: implications for expected returns and portfolio selection. Review of Financial Studies 13, 883–916] by estimating the Sharpe ratio of the optimal orthogonal portfolio. Our result, based on US industry portfolios for the period 1927–2002, reveals important risk factors missing from the CAPM during periods with high market volatility. We show that a priori fixing the Sharpe ratio, which is an assumption used by MacKinlay and Pastor (2000) [MacKinlay, A.C., Pastor, L., 2000. Asset pricing models: implications for expected returns and portfolio selection. Review of Financial Studies 13, 883–916], may produce less plausible estimates of the expected returns.},
  author       = {Asgharian, Hossein and Hansson, Björn},
  issn         = {0927-5398},
  keyword      = {Investment strategy,Orthogonal portfolio,Simulated annealing,Factor pricing},
  language     = {eng},
  number       = {4},
  pages        = {556--575},
  publisher    = {North-Holland},
  series       = {Journal of Empirical Finance},
  title        = {Evaluating the Importance of Missing Risk Factors Using the Optimal Orthogonal Portfolio Approach},
  url          = {http://dx.doi.org/10.1016/j.jempfin.2004.09.002},
  volume       = {12},
  year         = {2005},
}