Conditional Factor Models and Return Predictability

35 Pages Posted: 22 Mar 2005  

Alex P. Taylor

Manchester Business School

Date Written: February 2005

Abstract

This paper develops a new approach to examining the time variation of risk premia within the framework of conditional asset pricing models. By combining conditional factor models with approximate present-value relationships we derive a linear relationship between the log stock price and investors' expectations of future factor loadings, risk premia, and cashlows. This framework allows us to estimate conditional risk premia from a cross-sectional regression of log prices on proxies for expected factor loadings and cashflows. We apply this technique to various factor specifications including the CAPM, the three factors advocated by Fama & French (1996), and a five-factor model with economically motivated factors similar to Chen et al.(1986). Consistent with rational pricing we find that, for the majority of the risk factors, the estimated risk premia contain significant information about the future expected returns of the factor portfolios over the sample 1938-2003. Our framework abstracts from the use of ad-hoc conditioning variables, and offers a theoretically appealing approach to modelling the predictable components of stock returns. In recent samples (1978-2003) our estimates of the market risk premium prove to be better forecasters of market returns than the dividend-price ratio and other commonly used forecasting variables. Results from the economic factor model provide evidence that current levels of treasury and corporate bond yields are embedded in the cross section of equity market prices.

Keywords: conditional factor models, predictability

JEL Classification: G12

Suggested Citation

Taylor, Alex P., Conditional Factor Models and Return Predictability (February 2005). AFA 2006 Boston Meetings Paper. Available at SSRN: https://ssrn.com/abstract=687041 or http://dx.doi.org/10.2139/ssrn.687041

Alex P. Taylor (Contact Author)

Manchester Business School ( email )

Crawford House
Oxford Road
Manchester M13 9PL
United Kingdom

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