A multi-dynamic-factor model for stock returns

Abstract

In this paper, we define dynamic and static factors and distinguish between the dynamic and static structure of asset excess returns. We examine the value-weighted market portfolio as a dynamic factor and propose an intuitively appealing procedure to search for more dynamic factors. We find evidence that the market is a dynamic factor but a three-dynamic-factor model is superior in modelling the decile portfolios. The two additional factors are correlated with a January dummy and Bond risk premium and with production growth and a recession dummy, respectively. We found that small firms are more sensitive to the January/Bond risk factor, while large firms are more sensitive to the Production/Recession factor. We found that after accounting for the systematic risk corresponding to the three dynamic factors, there is not much of a static component of asset risk premium and there is no evidence for a higher `unexplained' return on small firm portfolios.