A Toolkit for Factor-Mimicking Portfolios

We relate Factor-Mimicking Portfolios (FMP) to the beta-pricing model and propose that each FMP should minimize the mispricing component of its underlying factor. We also examine FMP construction when the underlying factor contains noise and offer a new method to resolve this issue. For both classical and our newly proposed method, we recommend enhanced necessary criteria. FMPs of several macroeconomic factors constructed by our method satisfy this criterion. We find that equity returns are priced by consumption growth, inflation, and the unemployment rate; and corporate bond returns are priced by consumption growth, industrial production, and the default spread.