Dynamic Factor Models with Forward-Looking Views
Prediction models calibrated using historical data may forecast poorly if the dynamics of the present and future differ from observations in the past. For this reason, predictions can be improved if information like forward looking views about the state of the system are used to refine the forecast. We develop an approach for combining a dynamic factor model for risky asset prices calibrated on historical data, and noisy expert views of future values of the factors/covariates in the model, and study the implications for dynamic portfolio choice. By exploiting the graphical structure linking factors, asset prices, and views, we derive closed-form expressions for the dynamics of the factor and price processes after conditioning on the views. For linear factor models, the price process becomes a time-inhomogeneous affine process with a new covariate formed from the views. We establish a novel theoretical connection between the conditional factor process and a process we call a Mean-Reverting Bridge (MrB), an extension of the classical Brownian bridge. We derive the investor's optimal portfolio strategy and show that views influence both the myopic mean-variance term and the intertemporal hedge. The optimal dynamic portfolio when the long-run mean of the expected return is uncertain and learned online from data is also derived. More generally, our framework offers a generalizable approach for embedding forward-looking information about covariates in a dynamic factor model.