Deep Partial Least Squares for Empirical Asset Pricing

TL;DR

This paper introduces Deep Partial Least Squares (DPLS), a novel method for asset pricing that captures non-linear risk factor structures, outperforming traditional models and deep learning in explaining stock returns.

Contribution

The paper's main contribution is the development of DPLS, which models non-linear factor structures in asset returns, advancing deep learning applications in empirical finance.

Findings

DPLS achieves 1.2x higher information ratios than deep learning.

DPLS explains variation and pricing errors more effectively.

DPLS identifies key latent factors and characteristics.

Abstract

We use deep partial least squares (DPLS) to estimate an asset pricing model for individual stock returns that exploits conditioning information in a flexible and dynamic way while attributing excess returns to a small set of statistical risk factors. The novel contribution is to resolve the non-linear factor structure, thus advancing the current paradigm of deep learning in empirical asset pricing which uses linear stochastic discount factors under an assumption of Gaussian asset returns and factors. This non-linear factor structure is extracted by using projected least squares to jointly project firm characteristics and asset returns on to a subspace of latent factors and using deep learning to learn the non-linear map from the factor loadings to the asset returns. The result of capturing this non-linear risk factor structure is to characterize anomalies in asset returns by both linear risk factor exposure and interaction effects. Thus the well known ability of deep learning to capture outliers, shed lights on the role of convexity and higher order terms in the latent factor structure on the factor risk premia. On the empirical side, we implement our DPLS factor models and exhibit superior performance to LASSO and plain vanilla deep learning models. Furthermore, our network training times are significantly reduced due to the more parsimonious architecture of DPLS. Specifically, using 3290 assets in the Russell 1000 index over a period of December 1989 to January 2018, we assess our DPLS factor model and generate information ratios that are approximately 1.2x greater than deep learning. DPLS explains variation and pricing errors and identifies the most prominent latent factors and firm characteristics.