Title: Shrinking the Cross Section
Speaker: Stefan Nagel, Chicago Booth
Date: November 30, 2017
Location: Y2E2, Room 300
We construct a robust stochastic discount factor (SDF) that summarizes the joint explanatory power of a large number of cross-sectional stock return predictors. Our method achieves robust out-of sample performance in this high-dimensional setting by imposing an economically motivated prior on SDF coefficients that shrinks the contributions of low-variance principal components of the candidate factors. While empirical asset pricing research has focused on SDFs with a small number of characteristics-based factors—e.g., the four- or five-factor models discussed in the recent literature—we find that such a characteristics-sparse SDF cannot adequately summarize the cross-section of expected stock returns. However, a relatively small number of principal components of the universe of potential characteristics-based factors can approximate the SDF quite well.
Professor Nagel’s research focuses on asset pricing, investor behavior, and risk-taking of financial intermediaries. His most recent work explores the role of personal experiences in shaping expectations about the macroeconomy and financial market returns, novel approaches for measurement of bank tail risk exposures, and the application of machine learning techniques to understand the risk and return of investment strategies in the stock market. Nagel has won various awards for his research, among them the Smith-Breeden Prize of the American Finance Association for the best paper in the Journal of Finance in 2004 and the Fama/DFA prize for the best asset pricing paper in the Journal of Financial Economics in 2006 (first prize) and 2010 (second prize).Professor Nagel currently serves as the Executive Editor of the Journal of Finance, one of the leading academic finance journals in the world. Previously, he was an editor at the Review of Financial Studies from 2014-2015 and an associate editor at various top journals. He is also a research associate at the National Bureau of Economic Research (Cambridge, MA) and a research fellow at the Centre of Economic Policy Research (London, UK).Before joining Booth, Nagel taught at the University of Michigan's Ross School of Business (2013-17), Stanford Graduate School of Business (2004-13) and in the Economics Department at Harvard University (2003-04). He received his PhD from the London Business School in 2003 and his Diplom (M.S. equiv.) in Business Economics from the University of Trier (Germany) in 1999.