Is the Market Portfolio a Dynamic Factor? Evidence from Individual Stock Returns

This paper uses a factor model to test whether the market portfolio is a dynamic factor in the sense that individual stock returns contain a premium linked to the conditional risk of the market portfolio. The market conditional risk is based on a decomposition of the market variance into a time-varying trend component and a transitory component. The evidence shows that the conditional market premium is rising when the permanent trend rises relative to the conditional variance. The evidence for individual stock returns supports the notion that the market portfolio is a dynamic factor. Individual stock return autocorrelations are fully explained by the time variation in the market premium. The risk premia attributed to static factors are statistically insignificant.