Factor models with downside risk


We propose a conditional model of asset returns in the presence of common factors and downside risk. Specifically, we generalize existing latent factor models in three ways: we show how to estimate the threshold which identifies the 'disappointment' event triggering the bad state of the world; we permit different factor structures for asset returns in good and bad states; we show how to recover the observable factors' risk premia from the estimated latent ones in different states. The usefulness of the model is illustrated through two applications to cross-sections of asset returns in equity markets and other major asset classes. Paper link https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3937321

22 Aprile 2022

Lorenzo Trapani
University of Nottingham

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