Factor Models with Drifting Prices
87 Pages Posted: 12 Jul 2019 Last revised: 12 May 2021
Date Written: July 11, 2019
We propose a simple extension of the classical linear factor model where the deviations of a portfolio price from its permanent component emerge as a predictor for portfolio returns. Intuitively, when asset prices are above their trend, next period expected returns are lower. We discuss price deviations and return predictability within a simple model of diagnostic expectations. Furthermore, the price deviations are transitory if the factor model is able to track the buy-and-hold asset portfolio. Hence, the price deviations are useful to compare and select factor models. We conclude by studying the implications of our model for conditional asset pricing.
Keywords: Factor Models, Long-Horizon Returns, Mispricing, Predictability, Diagnostic Expectations.
JEL Classification: C38, G12, G17.
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