Distinguishing a Priced Risk from a Pricing Factor
Summary
The document explains two related asset-pricing concepts. A risk is priced when investors receive an average premium for bearing its exposure; in the CAPM example, beta is priced if higher-beta stocks are expected to earn higher long-run returns. A pricing factor has a stronger role: it helps explain or determine the prices of other assets.
It describes empirical assessment of a risk premium using long return histories across many stocks, estimating premiums with the Fama–MacBeth procedure and examining statistical significance. The answer cautions that findings can depend on which factors are included, since candidate factors may be correlated, and on the sample period. Statistical evidence for a premium alone does not establish that a variable is a useful pricing factor. The document offers conceptual guidance rather than a new empirical test or result.
Key ideas
- A risk is priced when its exposure is associated with an average risk premium.
- The CAPM predicts that higher-beta stocks should earn greater expected returns.
- A pricing factor helps explain the prices of assets, which is distinct from simply earning a premium.
- Fama–MacBeth estimates can be used to assess whether a candidate factor’s premium is statistically significant.
- Factor choice, correlations among factors, and sample period can affect empirical conclusions.
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Full text
# Is Beta a function or not # Is Beta a function or not What does it mean in if something isor not? ## Answer by nbbo2 (score 1) https://quant.stackexchange.com/a/53135 What does it mean in asset-pricing if something is priced or not? It means does the market take risk factor X into account when setting the price of an asset. If it does then on average the asset will earn a Risk Premium over time. In the case of Beta it means do High Beta stocks earn a high long term return like the CAPM predicts (the CAPM says investors dislike Beta and only buy high beta stocks if they expect a bigger return, i.e. if they can buy them at a cheap price. We say "in the CAPM Beta is priced"). How do we determine empirically whether X is priced or not? We need long time series on a large number of stocks. We estimate the risk premia using the Fama Macbeth procedure and look at the statistical significance of the RPs (according to FM method). However, there is always some controversy because another choice of risk factors may be significant also, and a lot of these risk factors are related to each other in any case.... which are the "correct" ones? And the exact time period used affects the quality of the results also. ## Answer by Alba (score 0) https://quant.stackexchange.com/a/53132 Note that there is a difference between something being priced and being a pricing factor. If it is priced, it just means that it has a positive risk premium; you are rewarded for taking the risk that corresponds to the factor. If it is a pricing factor, it is useful for pricing other assets. The difference is subtle, I recommend reading Cochrane: Asset Pricing for a detailed discussion.
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This summary was written by Stratmill's research agent from the original; it is not a copy of the source.