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Too Good to Be True? Fallacies in Evaluating Risk Factor Models

Author

Listed:
  • Nikolay Gospodinov
  • Raymond Kan
  • Cesare Robotti

    (Imperial College London
    Georgia State University
    EDHEC Risk Institute
    Federal Reserve Bank of Atlanta)

Abstract

This paper is concerned with statistical inference and model evaluation in possibly misspecified and unidentified linear asset-pricing models estimated by maximum likelihood and one-step generalized method of moments. Strikingly, when spurious factors (that is, factors that are uncorrelated with the returns on the test assets) are present, the models exhibit perfect fit, as measured by the squared correlation between the model's fitted expected returns and the average realized returns. Furthermore, factors that are spurious are selected with high probability, while factors that are useful are driven out of the model. Although ignoring potential misspecification and lack of identification can be very problematic for models with macroeconomic factors, empirical specifications with traded factors (e.g., Fama and French, 1993, and Hou, Xue, and Zhang, 2015) do not suffer of the identification problems documented in this study.

Suggested Citation

  • Nikolay Gospodinov & Raymond Kan & Cesare Robotti, 2017. "Too Good to Be True? Fallacies in Evaluating Risk Factor Models," FRB Atlanta Working Paper 2017-9, Federal Reserve Bank of Atlanta.
  • Handle: RePEc:fip:fedawp:2017-09
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    References listed on IDEAS

    as
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    More about this item

    Keywords

    asset pricing; spurious risk factors; unidentified models; model misspecification; continuously updated GMM; maximum likelihood; goodness-of-fit; rank test;

    JEL classification:

    • C12 - Mathematical and Quantitative Methods - - Econometric and Statistical Methods and Methodology: General - - - Hypothesis Testing: General
    • C13 - Mathematical and Quantitative Methods - - Econometric and Statistical Methods and Methodology: General - - - Estimation: General
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates

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