Factor Models with Drifting Prices
IGIER Working Paper No. 651
53 Pages Posted: 12 Jul 2019 Last revised: 12 Jun 2020
Date Written: July 11, 2019
Standard factor 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 mispricing. To address this issue,
we propose a novel (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 advance to validate factor models by the existence of such a
term. Empirically, we show that the ECT predicts equity portfolio returns. Furthermore,
we find evidence for a common component in the asset-specific ECTs
that is countercyclical and has forecasting ability for the aggregate market.
Keywords: Long-Horizon Returns, Predictability, Mispricing, Factor Models, Equilibrium Correction Term.
JEL Classification: C38, G11, G17.
Suggested Citation: Suggested Citation