Asset Pricing vs Asset Expected Returning in Factor Models

IGIER Working Paper No.. 651

42 Pages Posted: 12 Jul 2019 Last revised: 28 Jul 2019

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)

Date Written: July 11, 2019

Abstract

This paper proposes a new approach to factor modeling based on the long-run equilibrium relation between prices and related drivers of risk (integrated factors). We show that such relationship reveals an omitted variable in standard factor models for returns that we label as Equilibrium Correction Term (ECT). Omission of this term implies misspecification of every factor model for which the equilibrium (cointegrating) relation holds. The existence of this term implies short-run mispricing that disappears in the long-run. Such evidence of persistent but stationary idiosyncratic risk in prices is consistent with deviations from rational expectations. Its inclusion in a traditional factor model improves remarkably the performance of the model along several dimensions. Furthermore, the ECT – being predictive – has strong implications for risk measurement and portfolio allocation. A zero-cost investment strategy that consistently exploits temporary idiosyncratic mispricing earns an average annual excess return of 6.21%, mostly unspanned by existing factors.

Keywords: Asset Pricing, Asset Returns, Equilibrium Correction Term, Dynamic Factor Structure

JEL Classification: G11, G17

Suggested Citation

Favero, Carlo A. and Melone, Alessandro, Asset Pricing vs Asset Expected Returning in Factor Models (July 11, 2019). IGIER Working Paper No.. 651. 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 )

Welthandelsplatz 1
Vienna, 1020
Austria

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