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

70 Pages Posted: 27 Apr 2010 Last revised: 23 Aug 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)

Multiple version iconThere are 3 versions of this paper

Date Written: August 1, 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 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

Suggested Citation

Burnside, Craig, Empirical Asset Pricing and Statistical Power in the Presence of Weak Risk Factors (August 1, 2007). Duke Department of Economics Research Paper No. 46. Available at SSRN: https://ssrn.com/abstract=1596292 or http://dx.doi.org/10.2139/ssrn.1596292

Craig Burnside (Contact Author)

Duke University - Department of Economics ( email )

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University of Glasgow - Department of Economics

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National Bureau of Economic Research (NBER)

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