Dynamic Risk Premia and Asset Pricing Puzzles

Abstract

I apply a simple and intuitive econometric method to extract dynamic risk premia from the Fama-French (2015) multifactor asset pricing model. With all of the Fama-French (2015) state variables, this analysis is the first exploration of whether the pervasive asset pricing anomalies persist after the econometrician accounts for the time variation in multifactor risk premia. The ubiquitous anomalies of size, value, momentum, investment, profitability, short-term return reversal, and long-term return reversal, disappear after the econometrician takes into account the dynamic nature of multifactor risk premia. The prior linear empirical asset pricing models arise as special cases of this dynamic multifactor model. The main contribution of the current paper relates to the design of a workhorse model in the asset pricing literature. The previous linear empirical asset pricing models can be viewed as special cases of this more general dynamic multifactor model. This dynamic multifactor model carries important implications for equity cost estimation, corporate event assessment, financial risk management, and mutual fund performance evaluation. My dynamic analysis of multifactor risk premia from the Fama-French (2015) five-factor model proposes raising the hurdle for the conventional asset pricing tests. This recommendation serves as the time-series equivalent to the cross-sectional thesis of Harvey, Liu, and Zhu (2015).