Factor Selection in the Cross-section
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SeriesErasmus Econometric Institute Series
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SpeakersXiao Xiao (City, University of London, United Kingdom)
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FieldEconometrics
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LocationErasmus University Rotterdam, E building, room ET-14
Rotterdam -
Date and time
May 07, 2024
12:00 - 13:00
Abstract
We examine a new approach to selecting factors that have incremental information for explaining the cross-section of asset returns in the factor zoo. Our method can: (1) identify a set of factors that significantly explain the cross-sectional asset returns; (2) establish a hierarchical order to explain the importance of factors; (3) quantify unique contributions of each factor; and (4) address which factors can be subsumed by others and to what extent. In a simulation study with multiple settings for factor structures, we demonstrate that our method outperforms both stepwise regression (i.e., forward selection and backward selection) and LASSO regression. Empirically, we find that selected factors are dense instead of sparse in the stock market, the corporate bond market, and the options market. Joint paper with Chuanping Sun.