Expected returns and economic risk in Canadian financial markets

Abstract

This article estimates a linear factor model that links asset return fluctuations to: time-varying expected returns, to economic factors innovations and to a residual idiosyncratic risk. It considers bond returns together with returns on a number of portfolio of assets, grouped by sectors, traded on the Toronto Stock Exchange. The first part of the article identifies the number of latent variables necessary to explain the behaviour of these asset returns and concludes that two latent variables are needed. The second stage uses proxies for the underlying economic factors (state variables) and exploits the restrictions of the model to estimate conditional betas.