Asset Pricing Model Uncertainty: A Tradeoff between Bias and Variance. (13th December 2016)

• Record Type: Journal Article
• Authors: Zhou, Qing
• Other Names: Tian Weidong guestEditor.
• Is Part Of: International review of finance. Volume 17:Number 2(2017:Jun.)
• Page Start: 289
• Page End: 324
• Publication Date: 2016-12-13
• Subjects: Finance -- Periodicals; Financial institutions -- Periodicals; 332.673
• DOI: 10.1111/irfi.12112
• Languages: English
• ISSNs: 1369-412X

Abstract

Abstract: This paper draws a parallel between model combination and the mean–variance tradeoff in Modern Portfolio Theory (Markowitz 1952) and proposes a bias–variance tradeoff framework. Building on the bias–variance tradeoff framework, the paper proposes a Model Portfolio Approach (MPA) and a Global Minimum Variance(GMV) weighting scheme to mitigate asset pricing model uncertainty. Using a well‐conditioned pricing covariance estimator, the proposed approach improves out‐of‐sample pricing performance over six widely used asset pricing models, a model selection method and two most popular benchmarks in existing model combination studies, that is, the simple arithmetic average ("1/N") and Ordinary Least Square (OLS) weighting methods.