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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]
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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

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