Asset Pricing vs Asset Expected Returning in Factor-Portfolio Models
65 Pages Posted: 3 Mar 2020 Last revised: 24 Mar 2020
Date Written: March 2020
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: Suggested Citation