5. Conclusion

In this chapter, we give an overview of factor models that are applied to major capital markets. Ross' arbitrage pricing theory is chosen as the theoretical background for the stock and bond markets, since it allows to test for significant risk factors even if there are non-stationary features present in the data. In case of the corporate bond markets, Merton's approach is used to motivate which fundamental factors are chosen to explain market observations. We argue that the assumptions made in standard econometric procedures to test for significantly evaluated risk factors are responsible for the failure of finding the risk factors explain a higher proportion of developments on those markets in practice. We use the maximal overlap discrete wavelet transform to decompose the data into their time-scale components to allow for inefficiencies on capital markets and to allow for different time periods for adjustments to new information. The decomposition of the time series with wavelets in the time domain enables us to interpret data having features at different investment periods. This way we analyze the influence of various variables at different time scales. We examine the significance of risk factors and evaluate the proportion of variation explained at various time scales and find that fundamental factors are especially significant at longer time periods. Wavelet application allows for a thorough discrimination of various time horizons. The analysis is performed by the author for all major capital markets and we present new empirical research with regards to the European corporate bond market in detail as an example. A high percentage of variation in credit spreads explained by fundamental factors can be found in the medium terms (1.3– 2.6 years) for investment grade and high yield corporates. We conclude that the adjustment time period to new information is crucial for explaining the credit spreads by risk factors. Aggregating over the time scales veils the fact that a higher proportion in variation of credit spreads is explainable with the fundamental factors for the medium term and that the short term is driven by other factors. These findings confirm our previous findings for major capital markets where estimation and identification of significant fundamental risk factors improved when the analyses were done on a scale-by-scale basis.
