Interest-Rate Risk Factor and Stock Returns: A Time-Varying Factor-Loadings Model
31 Pages Posted: 8 Jan 2018 Last revised: 3 May 2018
Date Written: January 3, 2009
Abstract
We extend the Fama–French three-factor model to include a risk factor that proxies for interest-rate risk faced by firms in an attempt to reduce the pricing errors that the three-factor model cannot explain. These pricing errors are observed especially in small size and low book-to-market ratio firms, which are in general more sensitive to interest-rate risk. In addition, the factor loadings are modelled as time-varying so that the investors’ learning process can be taken into account. The results show that our Time-Varying-Loadings Four-Factor (TVL4) model significantly reduces the pricing errors.
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