A multifactor model of Philippine stock returns using latent macro risk factors

Abstract

This study addresses the measurement problem inherent in using published macroeconomic data to proxy for unobservable macro risk factors. Using a structural equation modelling framework, four latent risk factors are identified in addition to the exchange rate and market timing risk factors. The latter two are proxied one-for-one by fluctuations in the nominal peso-dollar exchange rate and the excess return on the portfolio represented by the Phisix. Using transformations of published macroeconomic data as indicator variables, the measurement part of the model appears to capture the essence of the unobservable risk factors they are supposed to measure. Variables used as such are called manifest exogenous variables (see Maruyama, 1998 or Hair et al., 1998). The betas or factor loadings generated by the structural model indicate that fluctuations in the risk factors have significant effects on the time variation of stock returns. However, the effects are more pronounced after the onset of the Asian financial crisis than before. Tests of model fit do not reject the hypothesis that the returns are consistent with the six-factor model for the entire period covered by the study, although individual factors are priced only during the 1997–2001 sub-period.