The Macroeconomy and Portfolio Risk
Factor models of security returns divide returns into components that are specific to individual assets or small groups of assets and components that are common and pervasive across many assets. The pervasive components are caused by new information or events that affect most or all assets. In many cases these pervasive shocks can be traced to new realizations or changes in expectations about macroeconomic variables. Understanding the relationships between asset returns and the macroeconomy gives the analyst a deeper understanding of the pervasive risks in security markets.
Section 5.1 discusses the estimation of macroeconomic factor models. Section 5.2 analyzes the empirical links between macroeconomic announcements and security returns. Section 5.3 considers how government macroeconomic policy rules can affect the link between macroeconomic variables and asset returns. Section 5.4 looks at dynamic market betas and their connections to the business cycle. Section 5.5 assesses the overall value and contribution of macroeconomic models in portfolio risk analysis applications.
Recall that an approximate factor model is a set of linear relations between excess returns x and k observable factors f with uncorrelated or weakly correlated residuals ε. In a macroeconomic factor model the factors driving returns are observed time series.
The realized return on an asset depends on the realized cash payments on the asset and capital gains or losses, which, in turn, are determined by changes in expected future cash payments and changes in discount rates. From the definition of return we have