On pricing kernels, information and risk

Abstract

This paper compares out-of-sample, ex-ante risk and returns of arbitrage pricing theory (APT) risk-factor based, zero-cost portfolios with characteristic-based, zero-cost portfolios. In particular the Haugen and Baker characteristic-based model framework is used in a comparison with the capital asset pricing model (CAPM) (Haugen, R. A., & Baker, L. N. (1996). Commonality in the determinants of expected stocks returns. Journal of Financial Economics, 41, 401–439), and three-factor Fama and French APT model portfolios to analyse returns of stocks listed on the Johannesburg Stock Exchange (Fama, E., & French, K. (1993). Common risk factors in the returns on stocks and bonds. Journal of Financial Economics, 33, 3–56). The finding that cross-sectional characteristic-based models have yielded portfolios with higher excess monthly returns but lower risk than their arbitrage pricing theory counterparts is discussed. Under the assumption of general no arbitrage conditions, it is argued that evidence in favour of characteristic-based pricing provides insight into the non-linear nature in which information is assimilated into pricing kernels for the market considered.