Factor Analysis and Arbitrage Pricing in Large Asset Economies

The paper develops a framework for factor analysis and arbitrage pricing in a large asset economy modeled as one with a continuum of assets. It is shown that the assumptions of absence of arbitrage opportunities and that returns have a strict factor structure imply exact factor-pricing for a full measure of assets. Interpreting finite subsets of assets as random draws from the underlying economy, there is probability one that every asset in a finite sample is exactly factor-priced. It is further shown that approximate factor structures exist in general and that they can be chosen optimally according to a measure of their explanatory power. Factor structures in the present model are also robust to asset repackaging and to the use of proxies to approximate the true factors. Journal of Economic Literature Classification numbers: G1, G12, C14. 1998 Academic Press