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Linear Approximations and Tests of Conditional Pricing Models
[A new approach to international arbitrage pricing]

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  • Michael W Brandt
  • David A Chapman

Abstract

If a nonlinear risk premium in a conditional asset pricing model is approximated with a linear function, as is commonly done in empirical research, the fitted model is misspecified. We use a generic reduced-form model economy with moderate risk premium nonlinearity to examine the size of the resulting misspecification-induced pricing errors. Pricing errors from moderate nonlinearity can be large, and a version of a test for nonlinearity based on risk premiums rather than pricing errors has reasonable power properties after properly controlling for the size of the test. We conclude by examining the importance of moderate nonlinearity in the context of the investment-specific technology shock models of Papanikolaou (2011) and Kogan and Papanikolaou (2014).

Suggested Citation

  • Michael W Brandt & David A Chapman, 2018. "Linear Approximations and Tests of Conditional Pricing Models [A new approach to international arbitrage pricing]," Review of Finance, European Finance Association, vol. 22(2), pages 455-489.
    • Handle: RePEc:oup:revfin:v:22:y:2018:i:2:p:455-489.
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    File URL: http://hdl.handle.net/10.1093/rof/rfy003
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    More about this item

    Keywords

    Conditional asset pricing model; Nonlinear risk premiums; Testing;
    All these keywords.

    JEL classification:

    • C58 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Financial Econometrics
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates

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