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Empirical Asset Pricing and Statistical Power in the Presence of Weak Risk Factors

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  • A. Craig Burnside

Abstract

The risk factors in many consumption-based asset pricing models display statistically weak correlation with the returns being priced. Some GMM-based procedures used to test these models have very low power to reject proposed stochastic discount factors (SDFs) when they are misspecified and the covariance matrix of the asset returns with the risk factors has less than full column rank. Consequently, these estimators provide potentially misleading positive assessments of the SDFs. Working with SDFs specified in terms of demeaned risk factors improves the performance of GMM but the power to reject misspecified SDFs may remain low. Two summary tests for failure of the rank condition have reasonable power, and lead to no Type I errors in Monte Carlo experiments.

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  • A. Craig Burnside, 2007. "Empirical Asset Pricing and Statistical Power in the Presence of Weak Risk Factors," NBER Working Papers 13357, National Bureau of Economic Research, Inc.
    • Handle: RePEc:nbr:nberwo:13357
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    Cited by:

    1. Manuel Arellano & Lars Peter Hansen & Enrique Sentana, 2009. "Underidentification? (Resumen)," Working Papers wp2009_0905, CEMFI.
    2. 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.
    3. Arellano, Manuel & Hansen, Lars Peter & Sentana, Enrique, 2012. "Underidentification?," Journal of Econometrics, Elsevier, vol. 170(2), pages 256-280.
    4. Francisco Peñaranda & Enrique Sentana, 2015. "A Unifying Approach to the Empirical Evaluation of Asset Pricing Models," The Review of Economics and Statistics, MIT Press, vol. 97(2), pages 412-435, May.
    5. Craig Burnside, 2016. "Identification and Inference in Linear Stochastic Discount Factor Models with Excess Returns," Journal of Financial Econometrics, Oxford University Press, vol. 14(2), pages 295-330.
    6. Craig Burnside & Martin Eichenbaum & Isaac Kleshchelski & Sergio Rebelo, 2011. "Do Peso Problems Explain the Returns to the Carry Trade?," The Review of Financial Studies, Society for Financial Studies, vol. 24(3), pages 853-891.
    7. Kevin Ross & Tommaso Mancini Griffoli, 2010. "Discussion: The Swiss Franc Exchange Rate and Deviations from Uncovered Interest Parity: Global vs Domestic Factors," Swiss Journal of Economics and Statistics (SJES), Swiss Society of Economics and Statistics (SSES), vol. 146(I), pages 373-384, March.
    8. Massimo Guidolin & Martin Lozano & Juan Arismendi Zambrano, "undated". "Multifactor Empirical Asset Pricing Under Higher-Order Moment Variations," Economics Department Working Paper Series n304-20.pdf, Department of Economics, National University of Ireland - Maynooth.
    9. 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.
    10. Olga Klinkowska, 2009. "Conditional Tests of Factor Augmented Asset Pricing Models with Human Capital and Housing: Some New Results," Ekonomia journal, Faculty of Economic Sciences, University of Warsaw, vol. 24.

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    JEL classification:

    • C33 - Mathematical and Quantitative Methods - - Multiple or Simultaneous Equation Models; Multiple Variables - - - Models with Panel Data; Spatio-temporal Models
    • F31 - International Economics - - International Finance - - - Foreign Exchange
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates

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