Factor Models with Drifting Prices

Abstract

Standard factor models focus on returns and leave prices undetermined. Thus, we propose a novel (co-)integrated methodology to factor modeling based on both prices and returns. Given a long-run relationship between the values of buy-and-hold portfolios and factors, we argue that a term---naturally labeled Equilibrium Correction Term (ECT)---should be included when regressing returns on factors. We also advance to validate factor models by the existence of such a term. Empirically, the ECT predicts equity portfolio returns. Furthermore, we find evidence for a common component in the asset-specific ECTs that is countercyclical and has forecasting ability for the aggregate market.

Keywords: Long-Horizon Returns, Predictability, Mispricing, Factor Models, Equilibrium Correction.

JEL Classification: C38, G11, G17.