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Linear Approximations and Tests of Conditional Pricing Models

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  • Michael W. Brandt
  • David A. Chapman

Abstract

We construct a simple reduced-form example of a conditional pricing model with modest intrinsic nonlinearity. The theoretical magnitude of the pricing errors (alphas) induced by the application of standard linear conditioning are derived as a direct consequence of an omitted variables bias. When the model is calibrated to either characteristics sorted or industry portfolios, we find that the alphas generated by approximation-induced specification error are economically large. A Monte Carlo analysis shows that finite-sample alphas are even larger. It also shows that the power to detect omitted nonlinear factors through tests based on estimated risk premiums can sometimes be quite low, even when the effect of misspecification on alphas is large.

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Bibliographic Info

Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 12513.

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Date of creation: Sep 2006
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Handle: RePEc:nbr:nberwo:12513

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Cited by:
  1. Orbe Mandaluniz, Susan & Ferreira García, María Eva & Gil Bazo, Javier, 2010. "Conditional beta pricing models: A nonparametric approach," BILTOKI 2010-10, Universidad del País Vasco - Departamento de Economía Aplicada III (Econometría y Estadística).
  2. Raymond Kan & Cesare Robotti, 2006. "Specification tests of asset pricing models using excess returns," Working Paper 2006-10, Federal Reserve Bank of Atlanta.
  3. Eva Ferreira & Javier Gil-Bazo & Susan Orbe, 2008. "Nonparametric estimation of conditional beta pricing models," Business Economics Working Papers wb082403, Universidad Carlos III, Departamento de Economía de la Empresa.

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