Factor Models with Downside Risk

We propose a conditional model of asset returns in the presence of common factors and downside risk. Specifically, we generalize existing latent factor models in three ways: we show how to estimate the threshold which identifies the 'disappointment' event triggering the bad state of the world; we permit different factor structures for asset returns in good and bad states; we show how to recover the observable factors' risk premia from the estimated latent ones in different states. The usefulness of the model is illustrated through two applications to cross-sections of asset returns in equity markets and other major asset classes