Factor Models with Drifting Prices

55 Pages Posted: 12 Jul 2019 Last revised: 21 Aug 2023

See all articles by Carlo A. Favero

Carlo A. Favero

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

Alessandro Melone

Ohio State University (OSU) - Fisher College of Business

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

Standard factor models focus on returns and leave prices undetermined. Thus, we propose a novel (co-)integrated methodology to factor modeling based on both prices and returns. Given a long-run relationship between the values of buy-and-hold portfolios and factors, we argue that a term---naturally labeled 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, 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.

JEL Classification: C38, G11, 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 Economics ( email )

Via Gobbi 5
Milan, 20136
Italy

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

Ohio State University (OSU) - Fisher College of Business ( email )

2100 Neil Avenue
Columbus, OH 43210-1144
United States

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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