Interest-Rate Risk Factor and Stock Returns : A Time-Varying Factor-Loadings Model

We extend the Fama–French three-factor model to include a risk factor that proxies for interest-rate risk faced by firms in an attempt to reduce the pricing errors that the three-factor model cannot explain. These pricing errors are observed especially in small size and low book-to-market ratio firms, which are in general more sensitive to interest-rate risk. In addition, the factor loadings are modelled as time-varying so that the investors' learning process can be taken into account. The results show that our Time-Varying-Loadings Four-Factor (TVL4) model significantly reduces the pricing errors