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Journal of Financial Econometrics Advance Access originally published online on May 6, 2009
Journal of Financial Econometrics 2009 7(3):247-264; doi:10.1093/jjfinec/nbp006
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© The Author 2009. Published by Oxford University Press. All rights reserved. For Permissions, please e-mail: journals.permissions@oxfordjournals.org.

A Dynamic Asset Pricing Model with Time-Varying Factor and Idiosyncratic Risk

Paskalis Glabadanidis
     Koç University

Address correspondence to Paskalis Glabadanidis, College of Administrative Sciences and Economics, Koç University, Rumelifeneri Yolu 34450, Sariyer, Istanbul, Turkey, or email: pglabadanidis{at}ku.edu.tr.

JEL Classification: C32, G12


  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: dynamic asset pricing, multivariate GARCH

I would like to thank James Bergin, Heber Farnsworth, Ugo Rigoni, John Scruggs, Jonathan Taylor, Yong Wang, Guofu Zhou, participants in the European Financial Management Association meetings in Athens, Greece, and seminar participants at City University of Hong Kong, Koç University, and Washington University in Saint Louis for their valuable help and suggestions. I am very grateful to the coeditor (Eric Ghysels) and two anonymous referees, whose valuable comments resulted in a greatly improved version of the paper. The usual disclaimer applies.

Received October 14, 2007; revised April 13, 2009; accepted April 21, 2009


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