Do the Q-Factors Proxy for Surprises in Economic State Variables?

Abstract

In this paper, we investigate whether q-factors, ME, I/A, and ROE correlates the surprises in economic state variables that describe the changes in investment opportunities within the Intertemporal CAPM framework. The paper shows that ME, I/A, and ROE significantly correlate with the surprises in economic state variables. In particular, we find that ME correlates with the surprises in default spread, term spread, and treasury-bill yield; while I/A is related to the surprises in aggregate dividend yield. The profitability factor ROE correlates with surprises in term spread and default spread. These findings suggest that the q-factors are related to the surprises in economic state variables. We also show that for each portfolio formation, loadings on surprises in economic state variables resemble the loadings or a mirror image of loading on q-factors. These findings suggest that the q-factors may act as a proxy for the surprises in economic state variables that describe the changes in the investment opportunity set. The paper adds more insights to the ongoing debate on the theoretical justification of q-factors ME, I/A, and ROE.