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Journal of Financial and Quantitative Analysis Vol. 45 No. 3 2010

Dynamic Factors and Asset Pricing

Zhongzhi He1,2; Sahn-Wook Huh3; Bong-Soo Lee4,5

1 Shanghai University of Finance and Economics · 2 Brock University · 3 University at Buffalo, State University of New York · 4 Florida State University · 5 Florida A&M University - Florida State University College of Engineering

Abstract

This study develops an econometric model that incorporates features of price dynamics across assets as well as through time. With the dynamic factors extracted via the Kalman filter, we formulate an asset pricing model, termed the dynamic factor pricing model (DFPM). We then conduct asset pricing tests in the in-sample and out-of-sample contexts. Our analyses show that the ex ante factors are a key component in asset pricing and forecasting. By using the ex ante factors, the DFPM improves upon the explanatory and predictive power of other competing models, including unconditional and conditional versions of the Fama and French (1993) 3-factor model. In particular, the DFPM can explain and better forecast the momentum portfolio returns, which are mostly missed by alternative models.

DOI
10.1017/s0022109010000207
Volume
45
Issue
3
Pages
707-737
Language
en
Sources
bibtex:phds-export.bib openalex crossref

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