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Misspecification-robust inference in linear asset pricing models with irrelevant risk factors

Author

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  • Gospodinov, Nikolay

    () (Federal Reserve Bank of Atlanta)

  • Kan, Raymond

    (University of Toronto)

  • Robotti, Cesare

Abstract

We show that in misspecified models with useless factors (for example, factors that are independent of the returns on the test assets), the standard inference procedures tend to erroneously conclude, with high probability, that these irrelevant factors are priced and the restrictions of the model hold. Our proposed model selection procedure, which is robust to useless factors 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. The practical relevance of our analysis is illustrated using simulations and empirical applications.

Suggested Citation

  • Gospodinov, Nikolay & Kan, Raymond & Robotti, Cesare, 2013. "Misspecification-robust inference in linear asset pricing models with irrelevant risk factors," FRB Atlanta Working Paper 2013-09, Federal Reserve Bank of Atlanta.
  • Handle: RePEc:fip:fedawp:2013-09
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    File URL: http://www.frbatlanta.org/documents/pubs/wp/wp1309.pdf
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    References listed on IDEAS

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    1. Kan, Raymond & Robotti, Cesare, 2008. "Specification tests of asset pricing models using excess returns," Journal of Empirical Finance, Elsevier, pages 816-838.
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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. 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.
    5. 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.
    6. 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.
    7. 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.
    8. Aleksejs Krecetovs & Pasquale Della Corte, 2016. "Macro uncertainty and currency premia," 2016 Meeting Papers 624, Society for Economic Dynamics.
    9. 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.
    10. Joachim Freyberger & Andreas Neuhierl & Michael Weber, 2017. "Dissecting Characteristics Nonparametrically," CESifo Working Paper Series 6391, CESifo Group Munich.
    11. repec:eee:empfin:v:44:y:2017:i:c:p:43-65 is not listed on IDEAS
    12. 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.
    13. Gospodinov, Nikolay & Kan, Raymond & Robotti, Cesare, 2015. "Asymptotic variance approximations for invariant estimators in uncertain asset-pricing models," FRB Atlanta Working Paper 2015-9, Federal Reserve Bank of Atlanta.
    14. Gospodinov, Nikolay & Kan, Raymond & Robotti, Cesare, 2016. "On the properties of the constrained Hansen–Jagannathan distance," Journal of Empirical Finance, Elsevier, pages 121-150.

    More about this item

    Keywords

    asset pricing models; lack of identification; model misspecification; GMM estimation;

    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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