On generalized arbitrage pricing theory analysis: empirical investigation of the macroeconomics modulated independent state-space model

Inception of Markowitz’s modern portfolio theory has also fuelled the development of asset pricing models for empirical finance, ranging from linear single-factor models like the capital asset pricing model to fairly complex multi-factor models such as the arbitrage pricing theory (APT). It is well-known in the literature of finance that APT could be used for modelling the underlying security returns generation process. In this paper, we investigate a generalized version of the APT model, called the macroeconomics modulated independent state-space model, in terms of model specification adequacy as well as its performance on prediction. Empirical results reveal that the model is not only well-specified, but also superior to the temporal factor analysis model in stock price and index forecasting, thanks to its salient capabilities of modelling both short-term and long-term market dynamics.