Dynamic Factors and Asset Pricing

46 Pages Posted: 11 Sep 2007 Last revised: 4 Oct 2008

See all articles by Zhongzhi Lawrence He

Zhongzhi Lawrence He

Brock University, Goodman School of Business

Sahn-Wook Huh

State University of New York (SUNY) - Department of Finance

Bong-Soo Lee

Florida State University

Date Written: September 29, 2008

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 as 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) three-factor model. In particular, the DFPM can explain and better forecast the momentum portfolio returns, which are mostly missed by other alternative models.

Keywords: Kalman filter, asset pricing, dynamic factors

JEL Classification: G12

Suggested Citation

He, Zhongzhi Lawrence and Huh, Sahn-Wook and Lee, Bong-Soo, Dynamic Factors and Asset Pricing (September 29, 2008). Available at SSRN: https://ssrn.com/abstract=1011828 or http://dx.doi.org/10.2139/ssrn.1011828

Zhongzhi Lawrence He

Brock University, Goodman School of Business ( email )

500 Glenridge Avenue
Finance
St. Catherine's, Ontario L2S 3A1
Canada

Sahn-Wook Huh (Contact Author)

State University of New York (SUNY) - Department of Finance ( email )

347 Jacobs Management Center
Buffalo, 14260-4000
United States
716-645-5435 (Phone)
716-645-3823 (Fax)

HOME PAGE: https://sites.google.com/site/sahnwookhuh/home

Bong-Soo Lee

Florida State University ( email )

423 Rovetta Business Building
Tallahassee, FL 32306-1110
United States
850-644-4713 (Phone)

HOME PAGE: http://www.cob.fsu.edu/fin/display_faculty_info.cfm?pID=401

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