Factor Models of Asset Returns and Bear Market Risk

We propose a conditional model of asset returns that allows for good and bad states of the world, depending on bear market risk. Specifically, we generalize existing latent factor models in three ways: we show how to estimate the threshold that identifies the “disappointment” event triggering the bad state of the world, we permit different factor structures for asset returns in good and bad states, and we show how to estimate consistently the conditional risk premia of observable factors from the estimated latent factors. The usefulness of the conditional model is illustrated with an empirical application to a broad cross-section of stock portfolio excess returns.

This paper was accepted by Kay Giesecke, finance.

Supplemental Material: The internet appendix and data files are available at https://doi.org/10.1287/mnsc.2023.04276.