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

69 Pages Posted: 27 Aug 2007 Last revised: 2 Jul 2010

See all articles by A. Craig Burnside

A. Craig Burnside

Duke University - Department of Economics; University of Glasgow - Department of Economics; National Bureau of Economic Research (NBER)

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Date Written: August 2007

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.

Suggested Citation

Burnside, Craig, Empirical Asset Pricing and Statistical Power in the Presence of Weak Risk Factors (August 2007). NBER Working Paper No. w13357. Available at SSRN: https://ssrn.com/abstract=1009807

Craig Burnside (Contact Author)

Duke University - Department of Economics ( email )

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United States

University of Glasgow - Department of Economics

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Glasgow, Scotland G12 8RT
United Kingdom

National Bureau of Economic Research (NBER)

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