Asset pricing models with unknown factors
Associate professor Hossein Asgharian
There is a long research history showing the existence of empirical anomalies in relation to the CAPM. There are two diametrically opposed ways
of explaining these phenomena. On the one hand, there is the rational school that is looking for risk sources beside the market portfolio. On the other
hand, there is a camp that mostly relates theses anomalies to irrational behavior of the investors.
We develop a method for testing CAPM based anomalies using a latent factor approach. This method enables us to estimate the upper limit of the
risk premium, due to observed as well as unobserved factors, that can be derived from a linear asset pricing model. As a corollary it is possible to divide
the observed average asset return into three parts: one explained by the market factor, one due to the unobserved factors, and finally the non-risk-based
component. This method is used to investigate whether the observed anomalies such as size and book-to-market effects are related to some risk factors
beside the market risk or if these effects are partly or entirely due to non-risk-based components e.g. irrational pricing or data-snooping.