A Protocol for Factor Identification

Abstract

We propose a protocol for identifying genuine risk factors. A genuine risk factor must be related to the covariance matrix of returns, must be priced in the cross-section of returns, and should yield a reward-to-risk ratio that is reasonable enough to be consistent with risk pricing. A market factor, a profitability factor, and traded versions of macroeconomic factors pass our protocol, but many characteristic-based factors do not. Several of the underlying characteristics, however, do command premiums in the cross-section. Received July 20, 2017; editorial decision June 9, 2018 by Editor Andrew Karolyi. Authors have furnished an Internet Appendix , which is available on the Oxford University Press Web site next to the link to the final published paper online.