Notes on dynamic factor pricing models

These notes discuss three aspects of dynamic factor pricing (i.e., APT) models. First, the diversifiable component of returns is unpredictable in a no-arbitrage world. Second, conditional factor loadings or betas have an unconditional factor structure when returns follow an unconditional factor structure, which provides a link between conditional and unconditional factor pricing models. Third, the estimation of dynamic factor pricing models is easily simplified in large cross sections when returns follow an unconditional factor structure. These results aid in the interpretation of existing applications and identify some of the issues in the formulation and estimation of dynamic factor pricing models.