Mimicking Portfolios with Conditioning Information

Mimicking portfolios have long been useful in asset pricing research. In most empirical applications, the portfolio weights are assumed to be fixed over time, while in theory they may be functions of the economic state. This paper derives and characterizes mimicking portfolios in the presence of predetermined state variables, or conditioning information. The results generalize and integrate multifactor minimum variance efficiency (Fama, 1996) with conditional and unconditional mean variance efficiency (Hansen and Richard (1987), Ferson and Siegel, 2001). Empirical examples illustrate the potential importance of timevarying mimicking portfolio weights and highlight challenges in their application. ∗ Ferson is the Collins Chair in Finance, Carroll School of Management, Boston College, Chestnut Hill, MA. and Research Associate, National Bureau of Economic Research. 140 Commonwealth Avenue, Chestnut Hill, MA. 02467. http://www2.bc.edu/~ferson, phone: (617) 552-6431, fax: (617) 552-0431, email [email protected]. Siegel is the Grant I. Butterbaugh Professor of Finance and Management Science and Adjunct Professor of Statistics at the University of Washington, Box 353200, Seattle, WA. 98195. Phone (206) 543-4773, email [email protected]. Pisun (Tracy) Xu is a doctoral student at the University of Washington Business School, Box 353200, Seattle, WA. 98195-3200, email [email protected]. We are grateful to Ken French and Owen Lamont for making data available and to Cesare Robotti, Sergei Sarkissian and participants at the 2004 European Finance Association meetings and the 2004 Conference on Financial Economics and Accounting for helpful discussions. The comments of the Editor, Stephen Brown, and of an anonymous referee were especially productive. Mimicking Portfolios with Conditioning Information this draft: December 14, 2004 Abstract Mimicking portfolios have long been useful in asset pricing research. In most empirical applications, the portfolio weights are assumed to be fixed over time, while in theory they may be functions of the economic state. This paper derives and characterizes mimicking portfolios in the presence of predetermined state variables, or conditioning information. The results generalize and integrate multifactor minimum variance efficiency (Fama, 1996) with conditional and unconditional mean variance efficiency (Hansen and Richard (1987), Ferson and Siegel, 2001). Empirical examples illustrate the potential importance of timevarying mimicking portfolio weights and highlight challenges in their application.Mimicking portfolios have long been useful in asset pricing research. In most empirical applications, the portfolio weights are assumed to be fixed over time, while in theory they may be functions of the economic state. This paper derives and characterizes mimicking portfolios in the presence of predetermined state variables, or conditioning information. The results generalize and integrate multifactor minimum variance efficiency (Fama, 1996) with conditional and unconditional mean variance efficiency (Hansen and Richard (1987), Ferson and Siegel, 2001). Empirical examples illustrate the potential importance of timevarying mimicking portfolio weights and highlight challenges in their application. 1