Dynamic factors and asset pricing: International and further U.S. evidence

•We consider the dynamic factor pricing model (DFPM) for international stock markets.•The dynamic factors are priced in the cross section of stock returns.•The dynamic factors have good forecasting performance.•The dynamic factors deliver economic value in asset allocation.

The Fama–French pricing model with dynamic factors (DFPM) extracted via the Kalman filter from the six size and book-to-market portfolios has a good performance in understanding stock returns. Using international stock market data, we find that the DFPM significantly improves the cross-sectional explanatory power of the Fama–French three-factor model. In the out-of-sample exercise, we find that the DFPM predicts portfolio returns more accurately than other competing models. The good forecasting performance of the DFPM is economically meaningful because the DFPM generally delivers significant utility gains in asset allocation.