Asset Pricing vs Asset Expected Returning in Factor Models
Carlo Favero () and
No 651, Working Papers from IGIER (Innocenzo Gasparini Institute for Economic Research), Bocconi University
This paper proposes a new approach to factor modeling based on the long-run equilibrium relation between prices and related drivers of risk (integrated factors). We show that such relationship reveals an omitted variable in standard factor models for returns that we label as Equilibrium Correction Term (ECT). Omission of this term implies misspecification of every factor model for which the equilibrium (cointegrating) relation holds. The existence of this term implies short-run mispricing that disappears in the long-run. Such evidence of persistent but stationary idiosyncratic risk in prices is consistent with deviations from rational expectations. Its inclusion in a traditional factor model improves remarkably the performance of the model along several dimensions. Furthermore, the ECT -being predictive- has strong implications for risk measurement and portfolio allocation. A zero-cost investment strategy that consistently exploits temporary idiosyncratic mispricing earns an average annual excess return of 6.21%, mostly unspanned by existing factors. Keywords: Asset Pricing, Asset Returns, Equilibrium Correction Term, Dynamic Factor Structure JEL Codes: G11, G17
New Economics Papers: this item is included in nep-fmk
References: View references in EconPapers View complete reference list from CitEc
Citations: Track citations by RSS feed
Downloads: (external link)
This item may be available elsewhere in EconPapers: Search for items with the same title.
Export reference: BibTeX
RIS (EndNote, ProCite, RefMan)
Persistent link: https://EconPapers.repec.org/RePEc:igi:igierp:651
Ordering information: This working paper can be ordered from
Access Statistics for this paper
More papers in Working Papers from IGIER (Innocenzo Gasparini Institute for Economic Research), Bocconi University via Rontgen, 1 - 20136 Milano (Italy).
Bibliographic data for series maintained by ().