Asset-Pricing Models and Economic Risk Premia: A Decomposition

Pierluigi Balduzzi and Cesare Robotti
Working Paper 2005-13
July 2005

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The risk premia assigned to economic (nontraded) risk factors can be decomposed into three parts: (i) the risk premia on maximum-correlation portfolios mimicking the factors; (ii) (minus) the covariance between the nontraded components of the candidate pricing kernel of a given model and the factors; and (iii) (minus) the mispricing assigned by the candidate pricing kernel to the maximum-correlation mimicking portfolios. The first component is the same across asset-pricing models and is typically estimated with little (absolute) bias and high precision. The second component, on the other hand, is essentially arbitrary and can be estimated with large (absolute) biases and low precisions by multi-beta models with nontraded factors. This second component is also sensitive to the criterion minimized in estimation. The third component is estimated reasonably well, both for models with traded and nontraded factors. We conclude that the economic risk premia assigned by multi-beta models with nontraded factors can be very unreliable. Conversely, the risk premia on maximum-correlation portfolios provide more reliable indications of whether a nontraded risk factor is priced. These results hold for both the constant and the time-varying components of the factor risk premia.

JEL classification: G12

Key words: economic risk premium, asset-pricing models, mispricing, maximum-correlation mimicking portfolios, nontraded factors

The authors thank Wayne Ferson, Jay Shanken, and seminar participants at Boston College, Concordia University, the Federal Reserve Bank of Atlanta, the 1999 Meetings of the Society for Computational Economics, and the 2000 Meetings of the European Finance Association for helpful discussions and comments. The views expressed here are the authors’ and not necessarily those of the Federal Reserve Bank of Atlanta or the Federal Reserve System. Any remaining errors are the authors’ responsibility.

Please address questions regarding content to Cesare Robotti, Federal Reserve Bank of Atlanta, 1000 Peachtree Street, NE, Atlanta, GA, 30309, phone 404-498-8543, fax 404-498-8810,