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Dynamics of Equity Factor Returns and Asset Pricing
[Dynamic Conditional Correlation: On Properties and Estimation]

Author

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  • Stoyan V Stoyanov
  • Francesco A Fabozzi

Abstract

In empirical equity asset pricing, the stochastic discount factor (SDF) is implicitly modeled as a linear function of equity factors and is influenced by the empirical properties of the factor returns. We investigate the pricing error introduced by a misspecified SDF which ignores each of the following established empirical phenomena: autocorrelation, dynamics of covariances, dynamics of correlations, and heavy tails for the conditional factor return distribution. We consider near-linear SDFs and nonlinear specifications characterized by a high degree of risk aversion. We find that assuming constant covariances or constant correlations can significantly overprice certain equity portfolios at all risk-aversion levels and that ignoring fat tails can lead to large pricing errors for some derivative assets for highly nonlinear SDFs.

Suggested Citation

  • Stoyan V Stoyanov & Francesco A Fabozzi, 2021. "Dynamics of Equity Factor Returns and Asset Pricing [Dynamic Conditional Correlation: On Properties and Estimation]," Journal of Financial Econometrics, Oxford University Press, vol. 19(1), pages 178-201.
    • Handle: RePEc:oup:jfinec:v:19:y:2021:i:1:p:178-201.
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    File URL: http://hdl.handle.net/10.1093/jjfinec/nbaa031
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    More about this item

    Keywords

    equity factors; volatility clustering; correlation dynamics; tail thickness; asset pricing;
    All these keywords.

    JEL classification:

    • C32 - Mathematical and Quantitative Methods - - Multiple or Simultaneous Equation Models; Multiple Variables - - - Time-Series Models; Dynamic Quantile Regressions; Dynamic Treatment Effect Models; Diffusion Processes; State Space Models
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates

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