Search Results
Working Paper
Robust inference in linear asset pricing models
We derive new results on the asymptotic behavior of the estimated parameters of a linear asset pricing model and their associated t-statistics in the presence of a factor that is independent of the returns. The inclusion of this "useless" factor in the model leads to a violation of the full rank (identification) condition and renders the inference nonstandard. We show that the estimated parameter associated with the useless factor diverges with the sample size but the misspecification-robust t-statistic is still well-behaved and has a standard normal limiting distribution. The asymptotic ...
Working Paper
Specification tests of asset pricing models using excess returns
We discuss the impact of different formulations of asset pricing models on the outcome of specification tests that are performed using excess returns. It is generally believed that when only excess returns are used for testing asset pricing models, the mean of the stochastic discount factor (SDF) does not matter. We show that the mean of the candidate SDF is only irrelevant when the model is correct. When the model is misspecified, the mean of the SDF can be a very important determinant of the specification test statistic, and it also heavily influences the relative rankings of competing ...
Working Paper
Dynamic strategies, asset pricing models, and the out-of-sample performance of the tangency portfolio
In this paper, I study the behavior of an investor with unit risk aversion who maximizes a utility function defined over the mean and the variance of a portfolio's return. Conditioning information is accessible without cost and an unconditionally riskless asset is available in the market. ; The proposed approach makes it possible to compare the performance of a benchmark tangency portfolio (formed from the set of unrestricted estimates of portfolio weights) to the performance of a restricted tangency portfolio which uses single-index and multi-index asset pricing models to constrain the first ...
Working Paper
Pricing model performance and the two-pass cross-sectional regression methodology
Since Black, Jensen, and Scholes (1972) and Fama and MacBeth (1973), the two-pass cross-sectional regression (CSR) methodology has become the most popular approach for estimating and testing asset pricing models. Statistical inference with this method is typically conducted under the assumption that the models are correctly specified, that is, expected returns are exactly linear in asset betas. This assumption can be a problem in practice since all models are, at best, approximations of reality and are likely to be subject to a certain degree of misspecification. We propose a general ...
Working Paper
Asymptotic variance approximations for invariant estimators in uncertain asset-pricing models
This paper derives explicit expressions for the asymptotic variances of the maximum likelihood and continuously updated GMM estimators under potentially misspecified models. The proposed misspecification-robust variance estimators allow the researcher to conduct valid inference on the model parameters even when the model is rejected by the data. Although the results for the maximum likelihood estimator are only applicable to linear asset-pricing models, the asymptotic distribution of the continuously updated GMM estimator is derived for general, possibly nonlinear, models. The large ...
Journal Article
The news in financial asset returns
The notion that financial asset returns are predictors of future economic activity is widespread, but detailed analyses provide little support for financial markets? ability to reveal future economic activity. Even though the evidence on various indicators used by different researchers is mixed, the authors of this article explore the notion that financial markets reveal useful information about future economic activity. ; This article examines and answers two questions: First, what is a good way of extracting information about future economic activity from asset prices? Second, do financial ...
Working Paper
Misspecification-robust inference in linear asset pricing models with irrelevant risk factors
We show that in misspecified models with useless factors (for example, factors that are independent of the returns on the test assets), the standard inference procedures tend to erroneously conclude, with high probability, that these irrelevant factors are priced and the restrictions of the model hold. Our proposed model selection procedure, which is robust to useless factors and potential model misspecification, restores the standard inference and proves to be effective in eliminating factors that do not improve the model's pricing ability. The practical relevance of our analysis is ...
Working Paper
Spurious Inference in Unidentified Asset-Pricing Models
This paper studies some seemingly anomalous results that arise in possibly misspecified and unidentified linear asset-pricing models estimated by maximum likelihood and one-step generalized method of moments (GMM). Strikingly, when useless factors (that is, factors that are independent of the returns on the test assets) are present, the models exhibit perfect fit, as measured by the squared correlation between the model's fitted expected returns and the average realized returns, and the tests for correct model specification have asymptotic power that is equal to the nominal size. In other ...
Working Paper
Mimicking portfolios, economic risk premia, and tests of multi-beta models
This paper considers two alternative formulations of the linear factor model (LFM) with nontraded factors. The first formulation is the traditional LFM, where the estimation of risk premia and alphas is performed by means of a cross-sectional regression of average returns on betas. The second formulation (LFM*) replaces the factors with their projections on the span of excess returns. This formulation requires only time-series regressions for the estimation of risk premia and alphas. We compare the theoretical properties of the two approaches and study the small-sample properties of estimates ...
Working Paper
Chi-squared tests for evaluation and comparison of asset pricing models
Using data for the Philippines, I develop and estimate a heterogeneous agent model to analyze the role of monetary policy in a small open economy subject to sizable remittance fluctuations. I include rule-of-thumb households with no access to financial markets and test whether remittances are countercyclical and serve as an insurance mechanism against macroeconomic shocks. When evaluating the welfare implications of alternative monetary rules, I consider both an anticipated large secular increase in the trend growth of remittances and random cyclical fluctuations around this trend. In a ...