A Dynamic Asset Pricing Model with Time-Varying Idiosyncratic Risk
62 Pages Posted: 8 Dec 2004
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: Suggested Citation
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