Factor Models with Drifting Prices

93 Pages Posted: 12 Jul 2019 Last revised: 8 Mar 2022

See all articles by Carlo A. Favero

Carlo A. Favero

Bocconi University - Department of Finance; Centre for Economic Policy Research (CEPR)

Alessandro Melone

Vienna Graduate School of Finance (VGSF)

Andrea Tamoni

Rutgers, The State University of New Jersey - Rutgers Business School at Newark & New Brunswick

Multiple version iconThere are 2 versions of this paper

Date Written: July 11, 2019

Abstract

This paper introduces a generalization of standard factor models where deviations of an asset price from its permanent component emerge as a predictor for returns. Intuitively, future expected returns are low (high) when asset prices are above (below) their fundamental value. We find support for this mechanism using a large set of anomalies and out-of-sample tests. We also discuss price deviations and return predictability within a diagnostic expectations framework. Moreover, our approach allows comparing different factor models in terms of their ability to track long-run portfolio returns. We conclude by studying the implications of our model for conditional asset pricing.

Keywords: Factor Models, Mispricing, Return Predictability, Diagnostic Expectations.

JEL Classification: C38, G12, G17.

Suggested Citation

Favero, Carlo A. and Melone, Alessandro and Tamoni, Andrea, Factor Models with Drifting Prices (July 11, 2019). Available at SSRN: https://ssrn.com/abstract=3418352 or http://dx.doi.org/10.2139/ssrn.3418352

Carlo A. Favero (Contact Author)

Bocconi University - Department of Finance ( email )

Via Roentgen 1
Milano, MI 20136
Italy

HOME PAGE: http://www.igier.unibocconi.it\favero

Centre for Economic Policy Research (CEPR)

London
United Kingdom

Alessandro Melone

Vienna Graduate School of Finance (VGSF) ( email )

WU Vienna
Welthandelsplatz 1
Vienna, 1020
Austria

HOME PAGE: http://https://sites.google.com/view/alessandro-melone/home

Andrea Tamoni

Rutgers, The State University of New Jersey - Rutgers Business School at Newark & New Brunswick ( email )

1 Washington Park
Newark, NJ 07102
United States

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