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Specification tests of asset pricing models using excess returns

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  • Kan, Raymond
  • Robotti, Cesare

Abstract

In this paper, we discuss the impact of different formulations of asset pricing models on the outcome of specification tests that are performed using excess returns. We point out that the popular way of specifying the stochastic discount factor (SDF) as a linear function of the factors is problematic because (1) the specification test statistic is not invariant to an affine transformation of the factors, and (2) the SDFs of competing models can have very different means. In contrast, an alternative specification that defines the SDF as a linear function of the de-meaned factors is free from these two problems and is more appropriate for model comparison. In addition, we suggest that a modification of the traditional Hansen-Jagannathan distance (HJ-distance) is needed when we use the de-meaned factors. The modified HJ-distance uses the inverse of the covariance matrix (instead of the second moment matrix) of excess returns as the weighting matrix to aggregate pricing errors. Asymptotic distributions of the modified HJ-distance and of the traditional HJ-distance based on the de-meaned SDF under correctly specified and misspecified models are provided. Finally, we propose a simple methodology for computing the standard errors of the estimated SDF parameters that are robust to model misspecification. We show that failure to take model misspecification into account is likely to understate the standard errors of the estimates of the SDF parameters and lead us to erroneously conclude that certain factors are priced.

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Bibliographic Info

Article provided by Elsevier in its journal Journal of Empirical Finance.

Volume (Year): 15 (2008)
Issue (Month): 5 (December)
Pages: 816-838

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Handle: RePEc:eee:empfin:v:15:y:2008:i:5:p:816-838

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Web page: http://www.elsevier.com/locate/jempfin

Related research

Keywords: Asset pricing models Specification tests Modified Hansen-Jagannathan distance Misspecification robust standard errors De-meaned stochastic discount factor;

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References

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Citations

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Cited by:
  1. Craig Burnside, 2010. "Identification and Inference in Linear Stochastic Discount Factor Models," NBER Working Papers 16634, National Bureau of Economic Research, Inc.
  2. Gospodinov, Nikolay & Kan, Raymond & Robotti, Cesare, 2013. "Chi-squared tests for evaluation and comparison of asset pricing models," Journal of Econometrics, Elsevier, vol. 173(1), pages 108-125.
  3. Kroencke, Tim A. & Schindler, Felix & Sebastian, Steffen & Theissen, Erik, 2013. "GDP mimicking portfolios and the cross-section of stock returns," ZEW Discussion Papers 13-026, ZEW - Zentrum für Europäische Wirtschaftsforschung / Center for European Economic Research.
  4. Raymond Kan & Cesare Robotti, 2007. "Model comparison using the Hansen-Jagannathan distance," Working Paper 2007-04, Federal Reserve Bank of Atlanta.
  5. A. Craig Burnside, 2010. "Empirical Asset Pricing and Statistical Power in the Presence of Weak Risk Factors," Working Papers 10-45, Duke University, Department of Economics.
  6. Gospodinov, Nikolay & Kan, Raymond & Robotti, Cesare, 2013. "Misspecification-robust inference in linear asset pricing models with irrelevant risk factors," Working Paper 2013-09, Federal Reserve Bank of Atlanta.
  7. Fletcher, Jonathan, 2014. "Benchmark models of expected returns in U.K. portfolio performance: An empirical investigation," International Review of Economics & Finance, Elsevier, vol. 29(C), pages 30-46.
  8. Stefan Nagel, 2012. "Empirical Cross-Sectional Asset Pricing," NBER Working Papers 18554, National Bureau of Economic Research, Inc.
  9. Nikolay Gospodinov & Raymond Kan & Cesare Robotti, 2012. "Robust inference in linear asset pricing models," Working Paper 2012-17, Federal Reserve Bank of Atlanta.
  10. 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.
  11. Francisco Peñaranda & Enrique Sentana, 2010. "A Unifying Approach To The Empirical Evaluation Of Asset Pricing Models," Working Papers wp2010_1004, CEMFI.
  12. Ravi Jagannathan & Srikant Marakani, 2011. "Price Dividend Ratio Factors : Proxies for Long Run Risk," NBER Working Papers 17484, National Bureau of Economic Research, Inc.
  13. 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.

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