Testing Conditional Asset Pricing Models Using a Markov Chain Monte Carlo Approach

28 Pages Posted: 13 May 2008  

Manuel Ammann

University of St. Gallen - School of Finance

Michael Verhofen

University of St. Gallen - Swiss Institute of Banking and Finance; Allianz Global Investors

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Abstract

We use Markov Chain Monte Carlo (MCMC) methods for the parameter estimation and the testing of conditional asset pricing models. In contrast to traditional approaches, it is truly conditional because the assumption that time variation in betas is driven by a set of conditioning variables is not necessary. Moreover, the approach has exact finite sample properties and accounts for errors-in-variables. Using S&P 500 panel data, we analyse the empirical performance of the CAPM and the Fama and French (1993) three-factor model. We find that time-variation of betas in the CAPM and the time variation of the coefficients for the size factor (SMB) and the distress factor (HML) in the three-factor model improve the empirical performance. Therefore, our findings are consistent with time variation of firm-specific exposure to market risk, systematic credit risk and systematic size effects. However, a Bayesian model comparison trading off goodness of fit and model complexity indicates that the conditional CAPM performs best, followed by the conditional three-factor model, the unconditional CAPM, and the unconditional three-factor model.

Suggested Citation

Ammann, Manuel and Verhofen, Michael, Testing Conditional Asset Pricing Models Using a Markov Chain Monte Carlo Approach. European Financial Management, Vol. 14, Issue 3, pp. 391-418, June 2008. Available at SSRN: https://ssrn.com/abstract=1132529 or http://dx.doi.org/10.1111/j.1468-036X.2007.00359.x

Manuel Ammann (Contact Author)

University of St. Gallen - School of Finance ( email )

Unterer Graben 21
St.Gallen, CH-9000
Switzerland

Michael Verhofen

Allianz Global Investors ( email )

Frankfurt
Germany

University of St. Gallen - Swiss Institute of Banking and Finance ( email )

Rosenbergstrasse 52
St. Gallen, CH-9000
Switzerland

HOME PAGE: http://www.verhofen.com

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