Explaining the Cross-Section of Returns with Macroeconomic Factors∗

This paper studies the link between the main sources of fundamental risk and asset returns by using the common components of a large number of macroeconomic time series variables as factors in a pricing model. A three-factor model with two common components and the market return as factors is found to explain the crosssection of size and book-to-market sorted stock portfolios better than standard benchmark models. The two common components proxy for business cycle risk and foreign exchange risk. The empirical results are robust to changes of the set of test assets and the exclusion of influential observations.