A Dynamic Asset Pricing Model with Time-Varying Factor and Idiosyncratic Risk

Paskalis Glabadanidis

Journal of Financial Econometrics, 2009, vol. 7, issue 3, 247-264

Abstract: This paper uses a multivariate GARCH model to account for time variation in factor loadings and idiosyncratic risk in improving the performance of the CAPM and the three-factor Fama--French model. I show how to incorporate time variation in betas and the second moments of the residuals in a very general way. Both the static and conditional CAPM substantially outperform the three-factor model in pricing industry portfolios. Using a dynamic CAPM model results in a 30% reduction in the average absolute pricing error of size/book-to-market portfolios. Ad hoc analysis shows that the market beta of a value-minus-growth portfolio decreases whenever the default premium increases as well as during economic recessions. Copyright The Author 2009. Published by Oxford University Press. All rights reserved. For Permissions, please e-mail: journals.permissions@oxfordjournals.org., Oxford University Press.

Date: 2009
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