A Dynamic Asset Pricing Model with Time-Varying Idiosyncratic Risk

62 Pages Posted: 8 Dec 2004

See all articles by Paskalis Glabadanidis

Paskalis Glabadanidis

Essential Services Commission of South Australia

Date Written: November 30, 2004

Abstract

This paper utilizes a state-of-the-art multivariate GARCH model to account for time-variation in idiosyncratic risk in improving the performance of the single-factor CAPM, the three factor Fama-French model and the four-factor Carhart model. I show how to incorporate time-variation in the second moments of the residuals in a very general way. When applied to the Fama and French (1993) size/book-to-market portfolio returns, I document a 50% reduction in the average absolute pricing error of this dynamic Fama-French model over the static one. In addition, I find that market betas of growth stocks increase during recessions while market betas of value stocks decrease during recessions and that HML betas of value stocks increase during recessions while HML betas of growth stocks decrease during recessions. Finally, for the Fama and French industry portfolios I find that the single-factor model outperforms the three and four factor models substantially both in their unconditional and conditional forms.

Keywords: Dynamic Asset Pricing, Multivariate GARCH

JEL Classification: G12, C32

Suggested Citation

Glabadanidis, Paskalis, A Dynamic Asset Pricing Model with Time-Varying Idiosyncratic Risk (November 30, 2004). Available at SSRN: https://ssrn.com/abstract=627686 or http://dx.doi.org/10.2139/ssrn.627686

Paskalis Glabadanidis (Contact Author)

Essential Services Commission of South Australia ( email )

Level 1, 151 Pirie Street
Adelaide, SA 5001
Australia

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