Hostname: page-component-cd9895bd7-jn8rn Total loading time: 0 Render date: 2025-01-05T13:48:33.690Z Has data issue: false hasContentIssue false
  • English
  • Français

Dynamic Factors and Asset Pricing

Published online by Cambridge University Press:  31 March 2010

Zhongzhi (Lawrence) He ,
Sahn-Wook Huh  and
Bong-Soo Lee
Zhongzhi (Lawrence) He
Affiliation:
Faculty of Business, Brock University, St. Catharines, Ontario L2S 3A1, Canada, and School of Finance, Shanghai University of Finance and Economics, Shanghai 200433. [email protected]
Sahn-Wook Huh
Affiliation:
School of Management, State University of New York at Buffalo, 246 Jacobs Management Ctr., Buffalo, NY 14260. [email protected]
Bong-Soo Lee
Affiliation:
College of Business, Florida State University, 311 Rovetta Business Bldg., Tallahassee, FL 32306. [email protected]
Get access Rights & Permissions [Opens in a new window]

Abstract

This study develops an econometric model that incorporates features of price dynamics across assets as well as through time. With the dynamic factors extracted via the Kalman filter, we formulate an asset pricing model, termed the dynamic factor pricing model (DFPM). We then conduct asset pricing tests in the in-sample and out-of-sample contexts. Our analyses show that the ex ante factors are a key component in asset pricing and forecasting. By using the ex ante factors, the DFPM improves upon the explanatory and predictive power of other competing models, including unconditional and conditional versions of the Fama and French (1993) 3-factor model. In particular, the DFPM can explain and better forecast the momentum portfolio returns, which are mostly missed by alternative models.

Type
Research Articles
Information
Journal of Financial and Quantitative Analysis , Volume 45 , Issue 3 , June 2010 , pp. 707 - 737
Copyright
Copyright © Michael G. Foster School of Business, University of Washington 2010

Access options

Get access to the full version of this content by using one of the access options below. (Log in options will check for institutional or personal access. Content may require purchase if you do not have access.)

References

Avramov, D., and Chordia, T.. “Asset Pricing Models and Financial Market Anomalies.” Review of Financial Studies, 19 (2006), 1001–1040.CrossRefGoogle Scholar
Brennan, M.; Wang, A.; and Xia, Y.. “Estimation and Test of a Simple Model of Intertemporal Capital Asset Pricing.” Journal of Finance, 59 (2004), 1743–1775.CrossRefGoogle Scholar
Carhart, M. “On Persistence in Mutual Fund Performance.” Journal of Finance, 52 (1997), 57–82.CrossRefGoogle Scholar
Chauvet, M., and Potter, S.. “Coincident and Leading Indicators of the Stock Market.” Journal of Empirical Finance, 7 (2000), 87–111.CrossRefGoogle Scholar
Cochrane, J. Asset Pricing, rev. ed.Princeton, NJ: Princeton University Press (2005).Google Scholar
Connor, G., and Korajczyk, R.. “Risk and Return in an Equilibrium APT: Applications of a New Test Methodology.” Journal of Financial Economics, 21 (1988), 255–289.CrossRefGoogle Scholar
Connor, G., and Korajczyk, R.. “An Intertemporal Equilibrium Beta Pricing Model.” Review of Financial Studies, 2 (1989), 373–392.Google Scholar
Daniel, K.; Hirshleifer, D.; and Subrahmanyam, A.. “Investor Psychology and Security Market Under- and Overreactions.” Journal of Finance, 53 (1998), 1839–1885.CrossRefGoogle Scholar
Daniel, K.; Hirshleifer, D.; and Subrahmanyam, A.. “Overconfidence, Arbitrage, and Equilibrium Asset Pricing.” Journal of Finance, 56 (2001), 921–965.CrossRefGoogle Scholar
Daniel, K., and Titman, S.. “Testing Factor-Model Explanations of Market Anomalies.” Working Paper, Northwestern University (2005).Google Scholar
Diebold, F., and Mariano, R.. “Comparing Predictive Accuracy.” Journal of Business and Economic Statistics, 13 (1995), 253–263.CrossRefGoogle Scholar
Evans, M. D. “Expected Returns, Time-Varying Risk, and Risk Premia.” Journal of Finance, 49 (1994), 655–679.Google Scholar
Fama, E. F., and French, K. R.. “Common Risk Factors in the Returns on Stocks and Bonds.” Journal of Financial Economics, 33 (1993), 3–56.Google Scholar
Fama, E. F., and French, K. R.. “Multifactor Explanations of Asset Pricing Anomalies.” Journal of Finance, 51 (1996), 55–84.Google Scholar
Ferson, W. E., and Harvey, C. R.. “The Variation of Economic Risk Premiums.” Journal of Political Economy, 99 (1991), 385–415.CrossRefGoogle Scholar
Ferson, W. E., and Harvey, C. R.. “Conditioning Variables and the Cross Section of Stock Returns.” Journal of Finance, 54 (1999), 1325–1360.CrossRefGoogle Scholar
Ferson, W. E., and Korajczyk, R. A.. “Do Arbitrage Pricing Models Explain the Predictability of Stock Returns?” Journal of Business, 68 (1995), 309–349.CrossRefGoogle Scholar
Ferson, W. E.; Sarkissian, S.; and Simin, T.. “Spurious Regressions in Financial Economics?” Journal of Finance, 58 (2003), 1393–1413.CrossRefGoogle Scholar
Ghysels, E. “On Stable Factor Structures in the Pricing of Risk: Do Time-Varying Betas Help or Hurt?” Journal of Finance, 53 (1998), 549–573.CrossRefGoogle Scholar
Gibbons, M. R., and , Ferson, W. E.. “Testing Asset Pricing Models with Changing Expectations and an Unobservable Market Portfolio.” Journal of Financial Economics, 14 (1985), 217–236.Google Scholar
Grinblatt, M., and Titman, S.. “The Relation between Mean-Variance Efficiency and Arbitrage Pricing.” Journal of Business, 60 (1987), 97–112.Google Scholar
Grundy, B. D., and Martin, J. S.. “Understanding the Nature of the Risks and the Source of the Rewards to Momentum Investing.” Review of Financial Studies, 14 (2001), 29–78.CrossRefGoogle Scholar
Hamilton, J. D. Time Series Analysis. Princeton, NJ: Princeton University Press (1994).CrossRefGoogle Scholar
Harvey, A. C. Forecasting, Structural Time Series Models and the Kalman Filter. Cambridge, UK: Cambridge University Press (1989).Google Scholar
Harvey, C. R., and Kirby, C.. “Instrumental Variables Estimation of Conditional Beta Pricing Models.” In Handbook of Statistics, Vol. 14, Maddala, G. S. and Rao, C. R., eds. Amsterdam, The Netherlands: North Holland (1996), 35–60.Google Scholar
Huberman, G.; Kandel, S.; and , Stambaugh, R. F.. “Mimicking Portfolios and Exact Arbitrage Pricing.” Journal of Finance, 42 (1987), 1–9.Google Scholar
Jagannathan, R., and Wang, Z.. “The Conditional CAPM and the Cross-Section of Expected Returns.” Journal of Finance, 51 (1996), 3–53.Google Scholar
Jegadeesh, N., and Titman, S.. “Cross-Sectional and Time-Series Determinants of Momentum Returns.” Review of Financial Studies, 15 (2002), 143–157.CrossRefGoogle Scholar
Kan, R., and Zhang, C.. “Two-Pass Tests of Asset Pricing Models with Useless Factors.” Journal of Finance, 54 (1999), 203–235.Google Scholar
Kim, C.-J., and Nelson, C. R.. State-Space Models with Regime Switching: Classical and Gibbs-Sampling Approaches with Applications. Cambridge, MA: MIT Press (1999).Google Scholar
Lehmann, B. N., and Modest, D. M.. “The Empirical Foundations of the Arbitrage Pricing Theory.” Journal of Financial Economics, 21 (1988), 213–254.CrossRefGoogle Scholar
Lewellen, J. “The Time-Series Relations among Expected Return, Risk, and Book-to-Market.” Journal of Financial Economics, 54 (1999), 5–43.Google Scholar
Lo, A., and MacKinlay, C.. “Data-Snooping Biases in Tests of Financial Asset Pricing Models.” Review of Financial Studies, 3 (1990), 431–467.Google Scholar
Merton, R. “An Intertemporal Capital Asset Pricing Model.” Econometrica, 41 (1973), 867–887.Google Scholar
Petkova, R. “Do the Fama-French Factors Proxy for Innovations in Predictive Variables?” Journal of Finance, 61 (2006), 581–612.CrossRefGoogle Scholar
Roll, R., and Ross, S. A.. “An Empirical Investigation of the Arbitrage Pricing Theory.” Journal of Finance, 35 (1980), 1073–1103.CrossRefGoogle Scholar
Ross, S. A. “The Arbitrage Theory of Capital Asset Pricing.” Journal of Economics Theory, 13 (1976), 341–360.CrossRefGoogle Scholar
Sentana, E. “Factor Representing Portfolios in Large Asset Markets.” Journal of Econometrics, 119 (2004), 257–289.CrossRefGoogle Scholar
Shanken, J. “On the Estimation of Beta-Pricing Models.” Review of Financial Studies, 5 (1992), 1–33.Google Scholar
Simin, T. “The Poor Predictive Performance of Asset Pricing Models.” Journal of Financial and Quantitative Analysis, 43 (2008), 355–380.CrossRefGoogle Scholar
Stambaugh, R. F. “Arbitrage Pricing with Information.” Journal of Financial Economics, 12 (1983), 357–369.Google Scholar
Stock, J. H., and Watson, M. W.. “New Indexes of Coincident and Leading Economic Indicators.” In NBER Macroeconomics Annual, Blanchard, O. J. and Fischer, S., eds. Cambridge, MA: MIT Press (1989), 351–394.Google Scholar
Stock, J. H., and Watson, M. W., “A Probability Model of the Coincident Economic Indicators.” In Leading Economic Indicators: New Approaches and Forecasting Records, Lahiri, K. and Moore, G. H., eds. Cambridge, UK: Cambridge University Press (1991), 63–89.Google Scholar
Wang, K. Q. “Variable Selection for Conditional Asset Pricing: An Out-of-Sample Analysis.” Working Paper, University of Toronto (2004).Google Scholar
Zhang, X. F. “Information Uncertainty and Stock Returns.” Journal of Finance, 61 (2006), 105–136.CrossRefGoogle Scholar