Combining IS-Demand and LM-Supply Factors
Posted: 5 Jun 2017 Last revised: 9 Dec 2019
Date Written: June 1, 2017
Abstract
This paper provides a basic quantitative description of a compendium of macro economic variables based on their ability to predict bond returns and stock returns. We use three methods (asymptotic PCA ,LASSO, and SVM) to construct factors out of 133 monthly time series of economic activity spanning a period from 1996:1 to 2015:12 and classify these factors into two groups: bond demand factors and bond supply factors. In PCA regression, we find both demand factors and supply factors are unspanned by bond yields and have strong predictability power for future bond excess returns beyond CP factors. This predictability finding is con firmed and enhanced by machine learning technique LASSO and SVM. More interestingly, LASSO can be used to identify 15 most important economic variables and give direct economic meanings to both demand factors and supply factors. Regarding to stock predictability, we find both demand and supply factors are priced by the cross-section of stock returns. In particular, portfolios with highest exposure to aggregate supply factor outperform portfolios with lowest exposure to aggregate supply factor 1.8% per month while portfolios with lowest exposure to aggregate demand factor outperform portfolios with highest exposure to aggregate demand factor 2.1% per month. This finding is consistent with "fly to safety" explanation. Furthermore, variance decomposition from VAR shows that demand factors are much more important than supply factors in explaining asset returns. Finally, we incorporate demand factors and supply factors into macro-finance affine-term structure (MTSMs) to estimate market price of risk of factors and find that demand factors affect level risk and supply factors affect slope risk. Moreover, MTSMs enable us to decompose bond yields into expectation component and yield risk premium component and we find MTSMs without macro factors under-estimate yield risk premium.
Keywords: Continuous-time Affine Term Structure, predictability of Bond, VAR, Stock Portfolio Sort
JEL Classification: C32, C55, E43, E44, G12
Suggested Citation: Suggested Citation