Can We Invest Based on Equity Risk Premia and Risk Factors from Multi-Factor Models?

Pawel Sakowski, Robert Ślepaczuk and Mateusz Wywiał
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Mateusz Wywiał: Faculty of Economic Sciences, University of Warsaw; Quedex Derivatives Exchange

No 2016-09, Working Papers from Faculty of Economic Sciences, University of Warsaw

Abstract: We find that detailed analysis of multi-factor models makes it possible to propose investment strategies based on equity risk premium disequlibrium. We examine two investment algorithms built on weekly data of world equity indices for emerging and developed countries in the period of 2000-2015. We create seven risk factors using additional data about market capitalisation, book value, country GDP and betas of equity indices. The first strategy utilises theoretical value of equity risk premium from seven-factor Markov-switching model with variables common for all countries and variables specific to developed/emerging countries. We compare theoretical with realised equity risk premium for a given index to undertake the buy/sell decisions. The second algorithm works only on eight risk factors and applies them as input variables to Markowitz models with alternative optimisation criteria (target risk, target return, maximum Sharpe ratio, minimum variance and equally weighted assets). Finally, we notice that the impact of risk factors on final results of investment strategy is much more important than the selection of a particular econometric model in order to correctly evaluate equity risk premium.

Keywords: investment algorithms; multi-factor models; Markov switching model; asset pricing models; equity risk premia; risk factors; Markowitz model (search for similar items in EconPapers)
JEL-codes: C15 F30 G11 G12 G13 G14 G15 (search for similar items in EconPapers)
Pages: 22 pages
Date: 2016
New Economics Papers: this item is included in nep-fmk, nep-pke and nep-upt
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (2)

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Persistent link: https://EconPapers.repec.org/RePEc:war:wpaper:2016-09

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