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

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 mis-specified 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 mis-specified 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 Classification: C33, F31, G12