International Review of Economics & Finance, Vol. 84, pp. 196-223, 2023

The Impact of Network Connectivity on Factor Exposures, Asset Pricing and Portfolio Diversification

This paper extends the classic factor-based asset pricing model by including network linkages, leading to a network-augmented linear factor model. This extension of the model allows a better understanding of the determinants of systematic risk and shows that cross-sectional risk premia can be estimated more precisely. Moreover, we demonstrate that in the presence of network links a misspecified traditional linear factor model presents residuals that are correlated and heteroskedastic. We support our claims with an extensive simulation experiment and real data.