Asset pricing with a factor-arch covariance structure

Abstract

In this paper we suggest using the FACTOR-ARCH model as a parsimonious structure for the conditional covariance matrix of asset excess returns. This structure allows us to study the dynamic relationship between asset risk premia and volatilities in a multivariate system. One and two FACTOR-ARCH models are successfully applied to pricing of Treasury bills. The results show stability over time, pass a variety of diagnostic tests, and compare favorably with previous empirical findings.