Semiparametric Estimation of a Characteristic-based Factor Model of Stock Returns

Abstract

This paper develops a new estimation procedure for characteristic-based factor models of stock returns. It describes a factor model in which the factor betas are smooth nonlinear functions of observed security characteristics. It develops an estimation procedure that combines nonparametric kernel methods for constructing mimicking portfolios with parametric nonlinear regression to estimate factor returns and factor betas. Factor models are estimated for UK and US common stocks using book-to-price ratio, market capitalization, and dividend yield.