Factor Models with Drifting Prices

IGIER Working Paper No. 651

53 Pages Posted: 12 Jul 2019 Last revised: 12 Jun 2020

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

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

Favero, Carlo A. and Melone, Alessandro and Tamoni, Andrea, Factor Models with Drifting Prices (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

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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