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Measuring the 'Dark Matter' in Asset Pricing Models

133 Pages Posted: 19 Sep 2013 Last revised: 9 Mar 2016

Hui Chen

Massachusetts Institute of Technology; National Bureau of Economic Research (NBER)

Winston Dou

The Wharton School, University of Pennsylvania

Leonid Kogan

Massachusetts Institute of Technology (MIT) - Sloan School of Management; National Bureau of Economic Research (NBER)

Date Written: June 30, 2015

Abstract

We propose a new quantitative measure of model fragility, based on the tendency of a model to over-fit the data in sample with poor out-of-sample performance. We formally show that structural economic models are fragile when the cross-equation restrictions they impose on the baseline statistical model appear excessively informative about combinations of model parameters that are otherwise difficult to estimate. We develop an analytically tractable asymptotic approximation to our fragility measure which we use to identify the problematic parameter combinations. Using these asymptotic results, we diagnose fragility in asset pricing models with rare disasters and long-run consumption risk.

Keywords: Cross-equation restriction; Information theory; Limited information likelihood; Model fragility and complexity; Robustness; Disaster risk; Long-run risk

JEL Classification: C1, D83, E44, G12

Suggested Citation

Chen, Hui and Dou, Winston and Kogan, Leonid, Measuring the 'Dark Matter' in Asset Pricing Models (June 30, 2015). Available at SSRN: https://ssrn.com/abstract=2326753 or http://dx.doi.org/10.2139/ssrn.2326753

Hui Chen (Contact Author)

Massachusetts Institute of Technology ( email )

50 Memorial Drive
Cambridge, MA 02142
United States
617-324-3896 (Phone)

National Bureau of Economic Research (NBER) ( email )

1050 Massachusetts Avenue
Cambridge, MA 02138
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Winston Dou

The Wharton School, University of Pennsylvania ( email )

2318 Steinberg Hall - Dietrich Hall
3620 Locust Walk
Philadelphia, PA 19104
United States

Leonid Kogan

Massachusetts Institute of Technology (MIT) - Sloan School of Management ( email )

100 Main Street
E62-636
Cambridge, MA 02142
United States
617-253-2289 (Phone)
617-258-6855 (Fax)

HOME PAGE: http://web.mit.edu/lkogan2/www/

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

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