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

51 Pages Posted: 6 Jan 2012

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: November 15, 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 is based on a Bayesian approach to modelling the latent process followed by risk exposures and idiosynchratic 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 modelling 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, Bayesian Multi-Factor Model of Instability in Prices and Quantities of Risk in U.S. Financial Markets (November 15, 2011). Manchester Business School Research Paper No. 619; Bocconi Legal Studies Research Paper No. 1980190. Available at SSRN: https://ssrn.com/abstract=1980190 or http://dx.doi.org/10.2139/ssrn.1980190

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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