Working Paper: CEPR ID: DP14417
Authors: Carlo A. Favero; Alessandro Melone
Abstract: Standard factor-portfolio models focus on returns and leave prices undetermined.This approach ignores information contained in the time-series of asset prices, relevant for long-term investors and for detecting potential mis-pricing.To address this issue, we provide a new (co-)integrated methodology to factor modeling based on both prices and returns.Given a long-run relationship between the value of buy-and-hold portfolios in test assets and factors, we argue that a term---naturally labeled as Equilibrium Correction Term (ECT)---should be included when regressing returns on factors.We also propose to validate factor models by the existence of such a term.Empirically, we show that the ECT predicts equity returns, both in-sample and out-of-sample.
Keywords: Return Predictability; Mispricing; Equilibrium Correction Term; Dynamic Factor Portfolio Models
JEL Codes: C38; G11; G17
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| deviations in prices from their long-run equilibrium (D59) | predictable future returns (G17) |
| equilibrium correction term (ECT) (C22) | predictable future returns (G17) |
| 1% log price deviation (E30) | decrease of 38 basis points in future log return (G17) |
| traditional factor models (C38) | potential mispricing (G13) |
| equilibrium correction term (ECT) (C22) | distinct predictive role (C52) |