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Asset pricing models with errors-in-variables

  • Carmichael, Benoît
  • Coën, Alain
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    This paper revisits Fama and French [Fama, Eugene F., French, Kenneth R., (1993) Common risk factors in the returns on stock and bonds. Journal of Financial Economics 33 (1), 3-56] and Carhart [Carhart, Mark M., 1997. On persistence in mutual fund performance. Journal of Finance 52 (1), 57-82] multifactor model taking into account the possibility of errors-in-variables. In their well known paper, Fama and French [Fama, Eugene F., French, Kenneth R., 1997. Industry costs of equity. Journal of Financial Economic 43 (2), 153-193] concluded that estimates of the cost of equity for the three-factor model of FF (1993) were imprecise. We argue that this imprecision is even more severe because of the pervasive effects of measurement errors. We propose Dagenais and Dagenais [Dagenais, Marcel G., Dagenais, Denyse L., 1997. Higher moment estimators for linear regression models with errors in the variables. Journal of Econometrics 76 (1-2), 193-221] higher moments estimator as a solution. Our results show that estimates of the cost of equity obtained with Dagenais and Dagenais estimator differ sharply from popular OLS estimates and shed a new light on performance attribution and abnormal performance ([alpha]). Adapting the Generalized Treynor Ratio, recently developed by Hübner [Hübner, Georges, 2005. The generalized treynor ratio. Review of Finance 9 (3), 415-435], we show that the performance of managed portfolios with multi-index models should be revisited in presence of errors-in-variables.

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

    Volume (Year): 15 (2008)
    Issue (Month): 4 (September)
    Pages: 778-788

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    Handle: RePEc:eee:empfin:v:15:y:2008:i:4:p:778-788
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    1. Georges Hübner, 2005. "The Generalized Treynor Ratio," Review of Finance, Springer, vol. 9(3), pages 415-435, 09.
    2. 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.
    3. Leamer, Edward E, 1987. "Errors in Variables in Linear Systems," Econometrica, Econometric Society, vol. 55(4), pages 893-909, July.
    4. White, Halbert, 1980. "A Heteroskedasticity-Consistent Covariance Matrix Estimator and a Direct Test for Heteroskedasticity," Econometrica, Econometric Society, vol. 48(4), pages 817-38, May.
    5. John G. Cragg, 1994. "Making Good Inferences from Bad Data," Canadian Journal of Economics, Canadian Economics Association, vol. 27(4), pages 776-800, November.
    6. 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 607-36, May-June.
    7. Aigner, Dennis J. & Hsiao, Cheng & Kapteyn, Arie & Wansbeek, Tom, 1984. "Latent variable models in econometrics," Handbook of Econometrics, in: Z. Griliches† & M. D. Intriligator (ed.), Handbook of Econometrics, edition 1, volume 2, chapter 23, pages 1321-1393 Elsevier.
    8. Carhart, Mark M, 1997. " On Persistence in Mutual Fund Performance," Journal of Finance, American Finance Association, vol. 52(1), pages 57-82, March.
    9. Eugene F. Fama & Kenneth R. French, . "Value Versus Growth: The International Evidence," CRSP working papers 449, Center for Research in Security Prices, Graduate School of Business, University of Chicago.
    10. Eugene F. Fama & Kenneth R. French, 2002. "The Equity Premium," Journal of Finance, American Finance Association, vol. 57(2), pages 637-659, 04.
    11. Dagenais, Marcel G. & Dagenais, Denyse L., 1997. "Higher moment estimators for linear regression models with errors in the variables," Journal of Econometrics, Elsevier, vol. 76(1-2), pages 193-221.
    12. Fama, Eugene F. & French, Kenneth R., 1997. "Industry costs of equity," Journal of Financial Economics, Elsevier, vol. 43(2), pages 153-193, February.
    13. Fama, Eugene F & French, Kenneth R, 1996. " Multifactor Explanations of Asset Pricing Anomalies," Journal of Finance, American Finance Association, vol. 51(1), pages 55-84, March.
    14. Pal, Manoranjan, 1980. "Consistent moment estimators of regression coefficients in the presence of errors in variables," Journal of Econometrics, Elsevier, vol. 14(3), pages 349-364, December.
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    16. Roll, Richard, 1977. "A critique of the asset pricing theory's tests Part I: On past and potential testability of the theory," Journal of Financial Economics, Elsevier, vol. 4(2), pages 129-176, March.
    17. Fama, Eugene F & French, Kenneth R, 1992. " The Cross-Section of Expected Stock Returns," Journal of Finance, American Finance Association, vol. 47(2), pages 427-65, June.
    18. 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.
    19. Connor, Gregory & Korajczyk, Robert A., 1986. "Performance measurement with the arbitrage pricing theory : A new framework for analysis," Journal of Financial Economics, Elsevier, vol. 15(3), pages 373-394, March.
    20. Kraus, Alan & Litzenberger, Robert H, 1976. "Skewness Preference and the Valuation of Risk Assets," Journal of Finance, American Finance Association, vol. 31(4), pages 1085-1100, September.
    21. Vikas Agarwal, 2004. "Risks and Portfolio Decisions Involving Hedge Funds," Review of Financial Studies, Society for Financial Studies, vol. 17(1), pages 63-98.
    22. Davidson, Russell & MacKinnon, James G., 1993. "Estimation and Inference in Econometrics," OUP Catalogue, Oxford University Press, number 9780195060119, March.
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