Bayesian solutions for the factor zoo: we just ran two quadrillion models

Bryzgalova, Svetlana, Huang, Jiantao and Julliard, Christian (2020) Bayesian solutions for the factor zoo: we just ran two quadrillion models. Systemic Risk Centre Discussion Papers (93). Systemic Risk Centre, The London School of Economics and Political Science, London, UK.

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Abstract

We propose a novel, and simple, Bayesian estimation and model selection procedure for crosssectional asset pricing. Our approach, that allows for both tradable and non-tradable factors, and is applicable to high dimensional cases, has several desirable properties. First, weak and spurious factors lead to diffuse, and centered at zero, posteriors for their market price of risk, making such factors easily detectable. Second, posterior inference is robust to the presence of such factors. Third, we show that flat priors for risk premia lead to improper marginal likelihoods, rendering model selection invalid. Therefore, we provide a novel prior, that is diffuse for strong factors but shrinks away useless ones, under which posterior probabilities are well behaved, and can be used for factor and (non necessarily nested) model selection, as well as model averaging, in large scale problems. We apply our method to a very large set of factors proposed in the literature, and analyse 2.25 quadrillion possible models, gaining novel insights on the empirical drivers of asset returns.

Item Type:	Monograph (Discussion Paper)
Official URL:	https://www.systemicrisk.ac.uk/
Additional Information:	© 2020 The Author(s)
Divisions:	Finance
Subjects:	H Social Sciences > HC Economic History and Conditions H Social Sciences > HG Finance
JEL classification:	G - Financial Economics > G1 - General Financial Markets > G12 - Asset Pricing; Trading volume; Bond Interest Rates C - Mathematical and Quantitative Methods > C1 - Econometric and Statistical Methods: General > C11 - Bayesian Analysis C - Mathematical and Quantitative Methods > C1 - Econometric and Statistical Methods: General > C12 - Hypothesis Testing C - Mathematical and Quantitative Methods > C5 - Econometric Modeling > C52 - Model Evaluation and Selection C - Mathematical and Quantitative Methods > C5 - Econometric Modeling > C59 - Other
Date Deposited:	13 Jun 2023 16:21
Last Modified:	16 Sep 2023 00:00
URI:	http://eprints.lse.ac.uk/id/eprint/118924

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