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

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  • Paskalis Glabadanidis

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.

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  • Paskalis Glabadanidis, 2009. "A Dynamic Asset Pricing Model with Time-Varying Factor and Idiosyncratic Risk," Journal of Financial Econometrics, Oxford University Press, vol. 7(3), pages 247-264, Summer.
    • Handle: RePEc:oup:jfinec:v:7:y:2009:i:3:p:247-264
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    File URL: http://hdl.handle.net/10.1093/jjfinec/nbp006
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    Cited by:

    1. Roumpis, Efthymios & Syriopoulos, Theodore, 2014. "Dynamics and risk factors in hedge funds returns: Implications for portfolio construction and performance evaluation," The Journal of Economic Asymmetries, Elsevier, vol. 11(C), pages 58-77.
    2. Salotti, Simone & Trecroci, Carmine, 2014. "Multifactor risk loadings and abnormal returns under uncertainty and learning," The Quarterly Review of Economics and Finance, Elsevier, vol. 54(3), pages 393-404.
    3. Hediger, Simon & Näf, Jeffrey, 2024. "Combining the MGHyp distribution with nonlinear shrinkage in modeling financial asset returns," Journal of Empirical Finance, Elsevier, vol. 77(C).
    4. Carmine Trecroci, 2012. "Uncertainty and the Dynamics of Multifactor Loadings and Pricing Errors," Economics Bulletin, AccessEcon, vol. 32(3), pages 2453-2463.

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