Portfolio Return Dynamics and Risk Price Heterogeneity

A model of portfolio return dynamics is developed in which the risk of price is permitted to be heterogeneous. In doing this, a novel method is proposed that delivers improved out-of-sample forecasts of portfolio returns. The main innovation is the use of a set of predictors that account for variation in risk prices across (segmented) markets. These predictors are the conditional covariances between the returns to the components of the portfolio under consideration and commonly used state variables (that is, French-French factor returns). The results indicate that the proposed method dominates competing methods (including those that assume homogeneous risk prices) when applied to domestic and international data — a finding that is robust to the performance measure and the state variables used