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Empirical Asset Pricing and Statistical Power in the Presence of Weak Risk Factors

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  • A. Craig Burnside

Abstract

The risk factors in many consumption-based asset pricing models display statistically weak correlation with the returns being priced. Some GMM-based procedures used to test these models have very low power to reject proposed stochastic discount factors (SDFs) when they are misspecified and the covariance matrix of the asset returns with the risk factors has less than full column rank. Consequently, these estimators provide potentially misleading positive assessments of the SDFs. Working with SDFs specified in terms of demeaned risk factors improves the performance of GMM but the power to reject misspecified SDFs may remain low. Two summary tests for failure of the rank condition have reasonable power, and lead to no Type I errors in Monte Carlo experiments.

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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 13357.

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Date of creation: Aug 2007
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Handle: RePEc:nbr:nberwo:13357

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Cited by:
  1. Manuel Arellano & Lars Peter Hansen & Enrique Sentana, 2009. "Underidentification?," CeMMAP working papers, Centre for Microdata Methods and Practice, Institute for Fiscal Studies CWP24/09, Centre for Microdata Methods and Practice, Institute for Fiscal Studies.
  2. A. Craig Burnside & Martin S. Eichenbaum & Isaac Kleshchelski & Sergio Rebelo, 2008. "Do Peso Problems Explain the Returns to the Carry Trade?," NBER Working Papers 14054, National Bureau of Economic Research, Inc.
  3. Craig Burnside, 2010. "Identification and Inference in Linear Stochastic Discount Factor Models with Excess Returns," NBER Working Papers 16634, National Bureau of Economic Research, Inc.
  4. Raymond Kan & Cesare Robotti, 2006. "Specification tests of asset pricing models using excess returns," Working Paper, Federal Reserve Bank of Atlanta 2006-10, Federal Reserve Bank of Atlanta.

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