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Two‐Pass Tests of Asset Pricing Models with Useless Factors

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  • Raymond Kan
  • Chu Zhang

Abstract

In this paper we investigate the properties of the standard two‐pass methodology of testing beta pricing models with misspecified factors. In a setting where a factor is useless, defined as being independent of all the asset returns, we provide theoretical results and simulation evidence that the second‐pass cross‐sectional regression tends to find the beta risk of the useless factor priced more often than it should. More surprisingly, this misspecification bias exacerbates when the number of time series observations increases. Possible ways of detecting useless factors are also examined.

Suggested Citation

  • 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.
  • Handle: RePEc:bla:jfinan:v:54:y:1999:i:1:p:203-235
    DOI: 10.1111/0022-1082.00102
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