IDEAS home Printed from https://ideas.repec.org/a/bla/jfinan/v68y2013i6p2617-2649.html
   My bibliography  Save this article

Pricing Model Performance and the Two‐Pass Cross‐Sectional Regression Methodology

Author

Listed:
  • RAYMOND KAN
  • CESARE ROBOTTI
  • JAY SHANKEN

Abstract

Over the years, many asset pricing studies have employed the sample cross‐sectional regression (CSR) R2 as a measure of model performance. We derive the asymptotic distribution of this statistic and develop associated model comparison tests, taking into account the impact of model misspecification on the variability of the CSR estimates. We encounter several examples of large R2 differences that are not statistically significant. A version of the intertemporal capital asset pricing model (CAPM) exhibits the best overall performance, followed by the Fama–French three‐factor model. Interestingly, the performance of prominent consumption CAPMs is sensitive to variations in experimental design.

Suggested Citation

  • Raymond Kan & Cesare Robotti & Jay Shanken, 2013. "Pricing Model Performance and the Two‐Pass Cross‐Sectional Regression Methodology," Journal of Finance, American Finance Association, vol. 68(6), pages 2617-2649, December.
    • Handle: RePEc:bla:jfinan:v:68:y:2013:i:6:p:2617-2649
    DOI: 10.1111/jofi.12035
    as

    Download full text from publisher

    File URL: https://doi.org/10.1111/jofi.12035
    Download Restriction: no
    File URL: https://libkey.io/10.1111/jofi.12035?utm_source=ideas
    LibKey link: if access is restricted and if your library uses this service, LibKey will redirect you to where you can use your library subscription to access this item
    ---><---

    Other versions of this item:

    References listed on IDEAS

    as
    1. Fama, Eugene F & French, Kenneth R, 1992. "The Cross-Section of Expected Stock Returns," Journal of Finance, American Finance Association, vol. 47(2), pages 427-465, June.
    2. Hansen, Lars Peter, 1982. "Large Sample Properties of Generalized Method of Moments Estimators," Econometrica, Econometric Society, vol. 50(4), pages 1029-1054, July.
    3. Shanken, Jay, 1990. "Intertemporal asset pricing : An Empirical Investigation," Journal of Econometrics, Elsevier, vol. 45(1-2), pages 99-120.
    4. Hansen, Lars Peter & Jagannathan, Ravi, 1997. "Assessing Specification Errors in Stochastic Discount Factor Models," Journal of Finance, American Finance Association, vol. 52(2), pages 557-590, June.
    5. Jagannathan, Ravi & Wang, Zhenyu, 1996. "The Conditional CAPM and the Cross-Section of Expected Returns," Journal of Finance, American Finance Association, vol. 51(1), pages 3-53, March.
    6. Whitney K. Newey & Kenneth D. West, 1994. "Automatic Lag Selection in Covariance Matrix Estimation," The Review of Economic Studies, Review of Economic Studies Ltd, vol. 61(4), pages 631-653.
    7. Lewellen, Jonathan & Nagel, Stefan & Shanken, Jay, 2010. "A skeptical appraisal of asset pricing tests," Journal of Financial Economics, Elsevier, vol. 96(2), pages 175-194, May.
    8. Shanken, Jay & Zhou, Guofu, 2007. "Estimating and testing beta pricing models: Alternative methods and their performance in simulations," Journal of Financial Economics, Elsevier, vol. 84(1), pages 40-86, April.
    9. Raymond Kan & Chu Zhang, 1999. "Two‐Pass Tests of Asset Pricing Models with Useless Factors," Journal of Finance, American Finance Association, vol. 54(1), pages 203-235, February.
    10. Martin Lettau & Sydney Ludvigson, 2001. "Resurrecting the (C)CAPM: A Cross-Sectional Test When Risk Premia Are Time-Varying," Journal of Political Economy, University of Chicago Press, vol. 109(6), pages 1238-1287, December.
    11. Fama, Eugene F. & French, Kenneth R., 1993. "Common risk factors in the returns on stocks and bonds," Journal of Financial Economics, Elsevier, vol. 33(1), pages 3-56, February.
    12. Hall, Alastair R. & Inoue, Atsushi, 2003. "The large sample behaviour of the generalized method of moments estimator in misspecified models," Journal of Econometrics, Elsevier, vol. 114(2), pages 361-394, June.
    13. Raymond Kan & Cesare Robotti, 2009. "Model Comparison Using the Hansen-Jagannathan Distance," Review of Financial Studies, Society for Financial Studies, vol. 22(9), pages 3449-3490, September.
    14. Newey, Whitney K., 1984. "A method of moments interpretation of sequential estimators," Economics Letters, Elsevier, vol. 14(2-3), pages 201-206.
    15. Jagannathan, Ravi & Kubota, Keiichi & Takehara, Hitoshi, 1998. "Relationship between Labor-Income Risk and Average Return: Empirical Evidence from the Japanese Stock Market," The Journal of Business, University of Chicago Press, vol. 71(3), pages 319-347, July.
    16. Vuong, Quang H, 1989. "Likelihood Ratio Tests for Model Selection and Non-nested Hypotheses," Econometrica, Econometric Society, vol. 57(2), pages 307-333, March.
    17. Newey, Whitney & West, Kenneth, 2014. "A simple, positive semi-definite, heteroscedasticity and autocorrelation consistent covariance matrix," Applied Econometrics, Russian Presidential Academy of National Economy and Public Administration (RANEPA), vol. 33(1), pages 125-132.
    18. Shanken, Jay, 1992. "On the Estimation of Beta-Pricing Models," Review of Financial Studies, Society for Financial Studies, vol. 5(1), pages 1-33.
    19. Cochrane, John H, 1996. "A Cross-Sectional Test of an Investment-Based Asset Pricing Model," Journal of Political Economy, University of Chicago Press, vol. 104(3), pages 572-621, June.
    20. Ravi Jagannathan & Zhenyu Wang, 1998. "An Asymptotic Theory for Estimating Beta-Pricing Models Using Cross-Sectional Regression," Journal of Finance, American Finance Association, vol. 53(4), pages 1285-1309, August.
    21. Ravi Jagannathan & Yong Wang, 2007. "Lazy Investors, Discretionary Consumption, and the Cross‐Section of Stock Returns," Journal of Finance, American Finance Association, vol. 62(4), pages 1623-1661, August.
    22. Ralitsa Petkova, 2006. "Do the Fama–French Factors Proxy for Innovations in Predictive Variables?," Journal of Finance, American Finance Association, vol. 61(2), pages 581-612, April.
    23. Shanken, Jay, 1985. "Multivariate tests of the zero-beta CAPM," Journal of Financial Economics, Elsevier, vol. 14(3), pages 327-348, September.
    24. Fama, Eugene F & MacBeth, James D, 1973. "Risk, Return, and Equilibrium: Empirical Tests," Journal of Political Economy, University of Chicago Press, vol. 81(3), pages 607-636, May-June.
    25. Raymond Kan & Cesare Robotti, 2009. "A note on the estimation of asset pricing models using simple regression betas," FRB Atlanta Working Paper 2009-12, Federal Reserve Bank of Atlanta.
    26. Kandel, Shmuel & Stambaugh, Robert F, 1995. "Portfolio Inefficiency and the Cross-Section of Expected Returns," Journal of Finance, American Finance Association, vol. 50(1), pages 157-184, March.
    27. Grauer, Robert R. & Janmaat, Johannus A., 2009. "On the power of cross-sectional and multivariate tests of the CAPM," Journal of Banking & Finance, Elsevier, vol. 33(5), pages 775-787, May.
    28. Chen, Nai-Fu & Roll, Richard & Ross, Stephen A, 1986. "Economic Forces and the Stock Market," The Journal of Business, University of Chicago Press, vol. 59(3), pages 383-403, July.
    29. Pagan, Adrian, 1984. "Econometric Issues in the Analysis of Regressions with Generated Regressors," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 25(1), pages 221-247, February.
    30. Douglas Rivers & Quang Vuong, 2002. "Model selection tests for nonlinear dynamic models," Econometrics Journal, Royal Economic Society, vol. 5(1), pages 1-39, June.
    31. R. Golden, 2003. "Discrepancy Risk Model Selection Test theory for comparing possibly misspecified or nonnested models," Psychometrika, Springer;The Psychometric Society, vol. 68(2), pages 229-249, June.
    32. Ferson, Wayne E & Schadt, Rudi W, 1996. "Measuring Fund Strategy and Performance in Changing Economic Conditions," Journal of Finance, American Finance Association, vol. 51(2), pages 425-461, June.
    33. Roll, Richard & Ross, Stephen A, 1994. "On the Cross-sectional Relation between Expected Returns and Betas," Journal of Finance, American Finance Association, vol. 49(1), pages 101-121, March.
    Full references (including those not matched with items on IDEAS)

    Most related items

    These are the items that most often cite the same works as this one and are cited by the same works as this one.
    1. Lewellen, Jonathan & Nagel, Stefan & Shanken, Jay, 2010. "A skeptical appraisal of asset pricing tests," Journal of Financial Economics, Elsevier, vol. 96(2), pages 175-194, May.
    2. Maio, Paulo & Santa-Clara, Pedro, 2012. "Multifactor models and their consistency with the ICAPM," Journal of Financial Economics, Elsevier, vol. 106(3), pages 586-613.
    3. Amit Goyal, 2012. "Empirical cross-sectional asset pricing: a survey," Financial Markets and Portfolio Management, Springer;Swiss Society for Financial Market Research, vol. 26(1), pages 3-38, March.
    4. Adrian, Tobias & Crump, Richard K. & Moench, Emanuel, 2015. "Regression-based estimation of dynamic asset pricing models," Journal of Financial Economics, Elsevier, vol. 118(2), pages 211-244.
    5. Hammami, Yacine & Lindahl, Anna, 2014. "An intertemporal capital asset pricing model with bank credit growth as a state variable," Journal of Banking & Finance, Elsevier, vol. 39(C), pages 14-28.
    6. Qi Shi & Bin Li & Adrian (Wai Kong) Cheung & Richard Chung, 2017. "Augmenting the intertemporal CAPM with inflation: Further evidence from alternative models," Australian Journal of Management, Australian School of Business, vol. 42(4), pages 653-672, November.
    7. Boons, M.F., 2014. "Sorting out commodity and macroeconomic risk in expected stock returns," Other publications TiSEM 1ebdac58-bf37-499d-8835-1, Tilburg University, School of Economics and Management.
    8. Stefano Gubellini, 2014. "Conditioning information and cross-sectional anomalies," Review of Quantitative Finance and Accounting, Springer, vol. 43(3), pages 529-569, October.
    9. Hammami, Yacine & Lindahl, Anna, 2013. "Estimating and testing beta pricing models on industries," Journal of Economics and Business, Elsevier, vol. 69(C), pages 45-63.
    10. repec:gnv:wpaper:unige:76321 is not listed on IDEAS
    11. Patrick Gagliardini & Elisa Ossola & Olivier Scaillet, 2016. "Time‐Varying Risk Premium in Large Cross‐Sectional Equity Data Sets," Econometrica, Econometric Society, vol. 84, pages 985-1046, May.
    12. Shanken, Jay & Zhou, Guofu, 2007. "Estimating and testing beta pricing models: Alternative methods and their performance in simulations," Journal of Financial Economics, Elsevier, vol. 84(1), pages 40-86, April.
    13. Gospodinov, Nikolay & Kan, Raymond & Robotti, Cesare, 2019. "Too good to be true? Fallacies in evaluating risk factor models," Journal of Financial Economics, Elsevier, vol. 132(2), pages 451-471.
    14. Balduzzi, Pierluigi & Robotti, Cesare, 2010. "Asset pricing models and economic risk premia: A decomposition," Journal of Empirical Finance, Elsevier, vol. 17(1), pages 54-80, January.
    15. Kan, Raymond & Robotti, Cesare, 2008. "Specification tests of asset pricing models using excess returns," Journal of Empirical Finance, Elsevier, vol. 15(5), pages 816-838, December.
    16. Kim, Soohun & Skoulakis, Georgios, 2018. "Ex-post risk premia estimation and asset pricing tests using large cross sections: The regression-calibration approach," Journal of Econometrics, Elsevier, vol. 204(2), pages 159-188.
    17. Maio, Paulo & Philip, Dennis, 2018. "Economic activity and momentum profits: Further evidence," Journal of Banking & Finance, Elsevier, vol. 88(C), pages 466-482.
    18. Couch, Robert & Wu, Wei, 2012. "Private investment and public equity returns," Journal of Economics and Business, Elsevier, vol. 64(2), pages 160-184.
    19. Kang, Jangkoo & Kim, Tong Suk & Lee, Changjun & Min, Byoung-Kyu, 2011. "Macroeconomic risk and the cross-section of stock returns," Journal of Banking & Finance, Elsevier, vol. 35(12), pages 3158-3173.
    20. Yacine Hammami, 2014. "An empirical investigation of asset pricing models under divergent lending and borrowing rates," Financial Markets and Portfolio Management, Springer;Swiss Society for Financial Market Research, vol. 28(3), pages 263-279, August.
    21. Roussanov, Nikolai, 2014. "Composition of wealth, conditioning information, and the cross-section of stock returns," Journal of Financial Economics, Elsevier, vol. 111(2), pages 352-380.

    More about this item

    JEL classification:

    • C1 - Mathematical and Quantitative Methods - - Econometric and Statistical Methods and Methodology: General
    • C12 - Mathematical and Quantitative Methods - - Econometric and Statistical Methods and Methodology: General - - - Hypothesis Testing: General
    • C13 - Mathematical and Quantitative Methods - - Econometric and Statistical Methods and Methodology: General - - - Estimation: General
    • C4 - Mathematical and Quantitative Methods - - Econometric and Statistical Methods: Special Topics
    • C52 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Model Evaluation, Validation, and Selection
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates

    Statistics

    Access and download statistics

    Corrections

    All material on this site has been provided by the respective publishers and authors. You can help correct errors and omissions. When requesting a correction, please mention this item's handle: RePEc:bla:jfinan:v:68:y:2013:i:6:p:2617-2649. See general information about how to correct material in RePEc.

    If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.

    If CitEc recognized a bibliographic reference but did not link an item in RePEc to it, you can help with this form .

    If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your RePEc Author Service profile, as there may be some citations waiting for confirmation.

    For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: Wiley Content Delivery (email available below). General contact details of provider: https://edirc.repec.org/data/afaaaea.html .

    Please note that corrections may take a couple of weeks to filter through the various RePEc services.

    IDEAS is a RePEc service. RePEc uses bibliographic data supplied by the respective publishers.