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A Bayesian multi-factor model of instability in prices and quantities of risk in U.S. financial markets

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  • Massimo Guidolin
  • Francesco Ravazzolo
  • Andrea Donato Tortora

Abstract

This paper analyzes the empirical performance of two alternative ways in which multi-factor models with time-varying risk exposures and premia may be estimated. The first method echoes the seminal two-pass approach advocated by Fama and MacBeth (1973). The second approach extends previous work by Ouysse and Kohn (2010) and is based on a Bayesian approach to modelling the latent process followed by risk exposures and idiosynchratic volatility. Our application to monthly, 1979-2008 U.S. data for stock, bond, and publicly traded real estate returns shows that the classical, two-stage approach that relies on a nonparametric, rolling window modelling of time-varying betas yields results that are unreasonable. There is evidence that all the portfolios of stocks, bonds, and REITs have been grossly over-priced. On the contrary, the Bayesian approach yields sensible results as most portfolios do not appear to have been misspriced and a few risk premia are precisely estimated with a plausibile sign. Real consumption growth risk turns out to be the only factor that is persistently priced throughout the sample.

Suggested Citation

  • Massimo Guidolin & Francesco Ravazzolo & Andrea Donato Tortora, 2011. "A Bayesian multi-factor model of instability in prices and quantities of risk in U.S. financial markets," Working Papers 2011-003, Federal Reserve Bank of St. Louis.
  • Handle: RePEc:fip:fedlwp:2011-003
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    File URL: http://research.stlouisfed.org/wp/2011/2011-003.pdf
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    References listed on IDEAS

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    1. de Pooter, M.D. & Ravazzolo, F. & Segers, R. & van Dijk, H.K., 2008. "Bayesian near-boundary analysis in basic macroeconomic time series models," Econometric Institute Research Papers EI 2008-13, Erasmus University Rotterdam, Erasmus School of Economics (ESE), Econometric Institute.
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    Cited by:

    1. Massimo Guidolin & Francesco Ravazzolo & Andrea Tortora, 2014. "Myths and Facts about the Alleged Over-Pricing of U.S. Real Estate," The Journal of Real Estate Finance and Economics, Springer, vol. 49(4), pages 477-523, November.
    2. Massimo Guidolin & Francesco Ravazzolo & Andrea Donato Tortora, 2011. "Myths and Facts about the Alleged Over-Pricing of U.S. Real Estate. Evidence from Multi-Factor Asset Pricing Models of REIT Returns," Working Papers 416, IGIER (Innocenzo Gasparini Institute for Economic Research), Bocconi University.
    3. Salotti, Simone & Trecroci, Carmine, 2014. "Multifactor risk loadings and abnormal returns under uncertainty and learning," The Quarterly Review of Economics and Finance, Elsevier, vol. 54(3), pages 393-404.

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    Keywords

    Econometric models ; Stochastic analysis ; Financial markets;

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