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The performance of cross-sectional regression tests of the CAPM with non-zero pricing errors

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  • Murtazashvili, Irina
  • Vozlyublennaia, Nadia

Abstract

We show that in the presence of non-zero pricing errors, the Fama–MacBeth (FM) cross-sectional regression test is very likely to either reject the Capital Asset Pricing Model (CAPM) when it (almost) holds or accept the model when it grossly fails. We investigate the case when pricing errors are correlated with betas and demonstrate that the test performance depends crucially on the correlation, cross-sectional distribution of betas, and several other parameter values. Even when the CAPM holds exactly (pricing errors are zero) the FM test is equally likely to either reject or accept the model when typical sample sizes are used.

Suggested Citation

  • Murtazashvili, Irina & Vozlyublennaia, Nadia, 2012. "The performance of cross-sectional regression tests of the CAPM with non-zero pricing errors," Journal of Banking & Finance, Elsevier, vol. 36(4), pages 1057-1066.
    • Handle: RePEc:eee:jbfina:v:36:y:2012:i:4:p:1057-1066
    DOI: 10.1016/j.jbankfin.2011.10.018
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    More about this item

    Keywords

    CAPM; Fama–MacBeth procedure; Pricing errors;
    All these keywords.

    JEL classification:

    • G10 - Financial Economics - - General Financial Markets - - - General (includes Measurement and Data)
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates

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