Asset Pricing vs Asset Expected Returning in Factor-Portfolio Models
IGIER Working Paper No. 651
59 Pages Posted: 12 Jul 2019 Last revised: 24 Mar 2020
Date Written: July 11, 2019
Standard factor-portfolio models focus on returns and leave prices undetermined. This approach ignores information contained in the time-series of asset prices, relevant for long-term investors and for detecting potential mis-pricing. To address this issue, we provide a new (co-)integrated methodology to factor modeling based on both prices and returns. Given a long-run relationship between the value of buy-and-hold portfolios in test assets and factors, we argue that a term-naturally labeled as Equilibrium Correction Term (ECT)-should be included when regressing returns on factors. We also propose to validate factor models by the existence of such a term. Empirically, we show that the ECT predicts equity returns, both in-sample and out-of-sample.
Keywords: Long-Horizon Returns, Predictability, Mispricing, Factor Models, Equilibrium Correction Term
JEL Classification: C38, G11, G17
Suggested Citation: Suggested Citation