Chapter 14: Latent Factor Models

Why Variance Rank Is Not Pricing Rank: The Math Behind RP-PCA advanced

The eigenvalue of a factor measures how much return variance it explains. Its risk premium measures how much expected return it commands. These are different numbers, and the gap between them is why standard PCA can miss the factors that matter most for asset pricing.

The eigenvalue of a factor measures how much return variance it explains. Its risk premium measures how much expected return it commands. These are different numbers, and the gap between them is why standard PCA can miss the factors that matter most for asset pricing.

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References

Estimating latent asset-pricing factors
Martin Lettau, Markus Pelger (2020) — Journal of Econometrics
Empirical Asset Pricing via Machine Learning
Shihao Gu, Bryan Kelly, Dacheng Xiu (2020) — The Review of Financial Studies