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

Craig Burnside

No 13357, NBER Working Papers from National Bureau of Economic Research, Inc

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.

JEL-codes: C33 F31 G12 (search for similar items in EconPapers)
Date: 2007-08
New Economics Papers: this item is included in nep-ecm
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Working Paper: Empirical Asset Pricing and Statistical Power in the Presence of Weak Risk Factors (2010)
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