Robust Inference in Linear Asset Pricing Models
90 Pages Posted: 23 Nov 2012 Last revised: 7 Jun 2016
Date Written: March 21, 2013
Many asset pricing models include risk factors that are only weakly correlated with the asset returns. We show that in the presence of a factor that is independent of the returns ("useless factor"), the standard inference procedures for evaluating its pricing ability could be highly misleading in misspecified models. Our proposed model selection procedure, which is robust to useless factors and potential model misspecification, restores the standard inference and proves to be effective in eliminating factors that do not improve the model's pricing ability. The practical relevance of our analysis is illustrated using simulations and an empirical application.
Keywords: Asset Pricing Models, Model Misspecification, Weak Identification, Useless Factor
JEL Classification: G12, C13, C32
Suggested Citation: Suggested Citation