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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
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
Model comparison using the Hansen-Jagannathan distance
Although it is of interest to empirical researchers to test whether or not a particular asset-pricing model is true, a more useful task is to determine how wrong a model is and to compare the performance of competing asset-pricing models. In this paper, we propose a new methodology to test whether two competing linear asset-pricing models have the same Hansen-Jagannathan distance. We show that the asymptotic distribution of the test statistic depends on whether the competing models are correctly specified or misspecified and are nested or nonnested. In addition, given the increasing interest ...
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
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 ...
Working Paper
The exact distribution of the Hansen-Jagannathan bound
Under the assumption of multivariate normality of asset returns, this paper presents a geometrical interpretation and the finite-sample distributions of the sample Hansen-Jagannathan (1991) bounds on the variance of admissible stochastic discount factors, with and without the nonnegativity constraint on the stochastic discount factors. In addition, since the sample Hansen-Jagannathan bounds can be very volatile, we propose a simple method to construct confidence intervals for the population Hansen-Jagannathan bounds. Finally, we show that the analytical results in the paper are robust to ...
Journal Article
Asset returns and economic risk
The capital asset pricing model (CAPM), favored by financial researchers and practitioners fifteen years ago, holds that the extra return on a risky asset comes from bearing market risk only. But newer evidence supports the intertemporal CAPM (I-CAPM) theory (Merton 1973), which suggests that the premium on any risky asset is related not only to market risk but also to additional economic variables. ; This article reviews and interprets recent advances in the asset pricing literature. The study seeks to shed light on the sources of economic risk that investors should track and hedge against ...
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
Financial market frictions
Market frictions, which exist even in efficient markets and change over time, impede trade but also offer profit opportunities. To provide a framework for understanding market frictions, the authors classify frictions into five categories.
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 ...