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Testing for monotonicity in expected asset returns

Author

Listed:
  • Joseph P. Romano
  • Michael Wolf

Abstract

Many postulated relations in finance imply that expected asset returns strictly increase in an underlying characteristic. To examine the validity of such a claim, one needs to take the entire range of the characteristic into account, as is done in the recent proposal of Patton and Timmermann (2010). But their test is only a test for the direction of monotonicity, since it requires the relation to be monotonic from the outset: either weakly decreasing under the null or strictly increasing under the alternative. When the relation is non-monotonic or weakly increasing, the test can break down and falsely ‘establish’ a strictly increasing relation with high probability. We offer some alternative tests that do not share this problem. The behavior of the various tests is illustrated via Monte Carlo studies. We also present empirical applications to real data.

Suggested Citation

  • Joseph P. Romano & Michael Wolf, 2011. "Testing for monotonicity in expected asset returns," ECON - Working Papers 017, Department of Economics - University of Zurich, revised Jan 2013.
  • Handle: RePEc:zur:econwp:017
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    File URL: http://www.econ.uzh.ch/static/wp/econwp017.pdf
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    More about this item

    Keywords

    Bootstrap; CAPM; monotonicity tests; non-monotonic relations;

    JEL classification:

    • C12 - Mathematical and Quantitative Methods - - Econometric and Statistical Methods and Methodology: General - - - Hypothesis Testing: General
    • C58 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Financial Econometrics
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G14 - Financial Economics - - General Financial Markets - - - Information and Market Efficiency; Event Studies; Insider Trading

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