A Dynamic Asset Pricing Model with Time-Varying Factor and Idiosyncratic Risk
34 Pages Posted: 30 Jun 2009 Last revised: 14 Aug 2017
Date Written: April 13, 2009
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.
Keywords: C32, G12, dynamic asset pricing, multivariate GARCH
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