Linear Approximations and Tests of Conditional Pricing Models*

A new approach to international arbitrage pricing

Michael W Brandt and David Chapman ()

Review of Finance, 2018, vol. 22, issue 2, 455-489

Abstract: If a nonlinear risk premium in a conditional asset pricing model is approximated with a linear function, as is commonly done in empirical research, the fitted model is misspecified. We use a generic reduced-form model economy with moderate risk premium nonlinearity to examine the size of the resulting misspecification-induced pricing errors. Pricing errors from moderate nonlinearity can be large, and a version of a test for nonlinearity based on risk premiums rather than pricing errors has reasonable power properties after properly controlling for the size of the test. We conclude by examining the importance of moderate nonlinearity in the context of the investment-specific technology shock models of Papanikolaou (2011) and Kogan and Papanikolaou (2014).

Keywords: Conditional asset pricing model; Nonlinear risk premiums; Testing (search for similar items in EconPapers)
JEL-codes: C58 G12 (search for similar items in EconPapers)
Date: 2018
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Citations: View citations in EconPapers (1)

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Working Paper: Linear Approximations and Tests of Conditional Pricing Models (2006)
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