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Misspecification-Robust Inference in Linear Asset-Pricing Models with Irrelevant Risk Factors

Author

Listed:
  • Nikolay Gospodinov
  • Raymond Kan
  • Cesare Robotti

Abstract

This paper shows that in misspecified models with risk factors that are uncorrelated with the test asset returns, the conventional inference methods tend to erroneously conclude, with high probability, that these factors are priced. Our proposed model selection procedure, which is robust to identification failure and potential model misspecification, restores the standard inference and proves to be effective in eliminating factors that do not improve the model's pricing ability. Applying our methodology to several popular asset-pricing models suggests that only the market and book-to-market factors appear to be priced, while the statistical evidence on the pricing ability of many macroeconomic factors is rather weak.

Suggested Citation

  • Nikolay Gospodinov & Raymond Kan & Cesare Robotti, 2014. "Misspecification-Robust Inference in Linear Asset-Pricing Models with Irrelevant Risk Factors," Review of Financial Studies, Society for Financial Studies, vol. 27(7), pages 2139-2170.
  • Handle: RePEc:oup:rfinst:v:27:y:2014:i:7:p:2139-2170.
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    File URL: http://hdl.handle.net/10.1093/rfs/hht135
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    References listed on IDEAS

    as
    1. Kan, Raymond & Robotti, Cesare, 2008. "Specification tests of asset pricing models using excess returns," Journal of Empirical Finance, Elsevier, vol. 15(5), pages 816-838, December.
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    Citations

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    Cited by:

    1. Adrian, Tobias & Crump, Richard K. & Moench, Emanuel, 2015. "Regression-based estimation of dynamic asset pricing models," Journal of Financial Economics, Elsevier, vol. 118(2), pages 211-244.
    2. Gospodinov, Nikolay & Kan, Raymond & Robotti, Cesare, 2017. "Too Good to Be True? Fallacies in Evaluating Risk Factor Models," FRB Atlanta Working Paper 2017-9, Federal Reserve Bank of Atlanta.
    3. Alexis Akira Toda & Kieran James Walsh, 2017. "Fat tails and spurious estimation of consumption‐based asset pricing models," Journal of Applied Econometrics, John Wiley & Sons, Ltd., vol. 32(6), pages 1156-1177, September.
    4. repec:taf:emetrv:v:37:y:2018:i:7:p:695-718 is not listed on IDEAS
    5. Stefano Giglio & Dacheng Xiu, 2017. "Inference on Risk Premia in the Presence of Omitted Factors," NBER Working Papers 23527, National Bureau of Economic Research, Inc.
    6. Beaulieu, Marie-Claude & Gagnon, Marie-Hélène & Khalaf, Lynda, 2016. "Less is more: Testing financial integration using identification-robust asset pricing models," Journal of International Financial Markets, Institutions and Money, Elsevier, vol. 45(C), pages 171-190.
    7. Khalaf, Lynda & Schaller, Huntley, 2016. "Identification and inference in two-pass asset pricing models," Journal of Economic Dynamics and Control, Elsevier, vol. 70(C), pages 165-177.
    8. Peter Christoffersen & Mathieu Fournier & Kris Jacobs & Mehdi Karoui, 2015. "Option-Based Estimation of the Price of Co-Skewness and Co-Kurtosis Risk," CREATES Research Papers 2015-54, Department of Economics and Business Economics, Aarhus University.
    9. Aleksejs Krecetovs & Pasquale Della Corte, 2016. "Macro uncertainty and currency premia," 2016 Meeting Papers 624, Society for Economic Dynamics.
    10. Patrick Gagliardini & Elisa Ossola & O. Scaillet, 2016. "A Diagnostic Criterion for Approximate Factor Structure," Swiss Finance Institute Research Paper Series 16-51, Swiss Finance Institute, revised Dec 2016.
    11. Joachim Freyberger & Andreas Neuhierl & Michael Weber, 2017. "Dissecting Characteristics Nonparametrically," CESifo Working Paper Series 6391, CESifo Group Munich.
    12. repec:eee:empfin:v:44:y:2017:i:c:p:43-65 is not listed on IDEAS
    13. repec:eee:ecolet:v:163:y:2018:i:c:p:190-192 is not listed on IDEAS
    14. Shang, Hua & Yuan, Ping & Huang, Lin, 2016. "Macroeconomic factors and the cross-section of commodity futures returns," International Review of Economics & Finance, Elsevier, vol. 45(C), pages 316-332.
    15. Nikolay Gospodinov & Raymond Kan & Cesare Robotti, 2018. "Asymptotic variance approximations for invariant estimators in uncertain asset-pricing models," Econometric Reviews, Taylor & Francis Journals, vol. 37(7), pages 695-718, August.
    16. repec:bla:eufman:v:24:y:2018:i:2:p:239-260 is not listed on IDEAS
    17. Gospodinov, Nikolay & Kan, Raymond & Robotti, Cesare, 2016. "On the properties of the constrained Hansen–Jagannathan distance," Journal of Empirical Finance, Elsevier, vol. 36(C), pages 121-150.

    More about this item

    JEL classification:

    • C12 - Mathematical and Quantitative Methods - - Econometric and Statistical Methods and Methodology: General - - - Hypothesis Testing: General
    • C52 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Model Evaluation, Validation, and Selection
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates

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