Asset Pricing vs Asset Expected Returning in Factor-Portfolio Models

65 Pages Posted: 3 Mar 2020 Last revised: 24 Mar 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)

Multiple version iconThere are 2 versions of this paper

Date Written: March 2020

Abstract

Standard factor-portfolio 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 mis-pricing.

To address this issue, we provide a new (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 propose to validate factor models by the existence of such a term.

Empirically, we show that the ECT predicts equity returns, both in-sample and out-of-sample.

Keywords: Dynamic Factor-Portfolio Models, Equilibrium Correction Term, mispricing, return predictability

JEL Classification: C38, G11, G17

Suggested Citation

Favero, Carlo A. and Melone, Alessandro, Asset Pricing vs Asset Expected Returning in Factor-Portfolio Models (March 2020). CEPR Discussion Paper No. DP14417, Available at SSRN: https://ssrn.com/abstract=3547350

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 )

Vienna
Austria

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