A Bayesian Multi-Factor Model of Instability in Prices and Quantities of Risk in U.S. Financial Markets

Federal Reserve Bank of Saint Louis Working Paper No. 2011-003A

51 Pages Posted: 20 Jan 2011

See all articles by Massimo Guidolin

Massimo Guidolin

Bocconi University - Department of Finance

Francesco Ravazzolo

Free University of Bolzano

Andrea Donato Tortora

Bocconi University

Date Written: January 19, 2011

Abstract

This paper analyzes the empirical performance of two alternative ways in which multi-factor models with time-varying risk exposures and premia may be estimated. The first method echoes the seminal two-pass approach advocated by Fama and MacBeth (1973). The second approach extends previous work by Ouysse and Kohn (2010) and is based on a Bayesian approach to modeling the latent process followed by risk exposures and idiosyncratic volatility. Our application to monthly, 1979-2008 U.S. data for stock, bond, and publicly traded real estate returns shows that the classical, two-stage approach that relies on a nonparametric, rolling window modeling of time-varying betas yields results that are unreasonable. There is evidence that all the portfolios of stocks, bonds, and REITs have been grossly over-priced. On the contrary, the Bayesian approach yields sensible results as most portfolios do not appear to have been misspriced and a few risk premia are precisely estimated with a plausible sign. Real consumption growth risk turns out to be the only factor that is persistently priced throughout the sample.

Keywords: Bayesian Estimation, Latent Jumps, Stochastic Volatility, Linear Factor Models

JEL Classification: G11, C53

Suggested Citation

Guidolin, Massimo and Ravazzolo, Francesco and Tortora, Andrea Donato, A Bayesian Multi-Factor Model of Instability in Prices and Quantities of Risk in U.S. Financial Markets (January 19, 2011). Federal Reserve Bank of Saint Louis Working Paper No. 2011-003A. Available at SSRN: https://ssrn.com/abstract=1743662 or http://dx.doi.org/10.2139/ssrn.1743662

Massimo Guidolin (Contact Author)

Bocconi University - Department of Finance ( email )

Via Roentgen 1
Milano, MI 20136
Italy

Francesco Ravazzolo

Free University of Bolzano ( email )

Bolzano
Italy

Andrea Donato Tortora

Bocconi University ( email )

Via Sarfatti, 25
Milan, MI 20136
Italy

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