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Testing Factor Models on Characteristic and Covariance Pure Plays

47 Pages Posted: 24 Jun 2015 Last revised: 13 Aug 2015

Kerry Back

Rice University - Jones Graduate School of Business and Department of Economics

Nishad Kapadia

Tulane University - A.B. Freeman School of Business

Barbara Ostdiek

Rice University - Jesse H. Jones Graduate School of Business

Date Written: July 16, 2015

Abstract

We test the recent Fama-French five-factor model and Hou-Xue-Zhang four-factor model using test assets from Fama-MacBeth regressions, which are pure plays on particular characteristics or covariances. Our tests resolve the errors-in-variable bias in Fama-MacBeth regressions with estimated betas. Monte Carlo evidence shows that the tests are unbiased even with time-varying stock betas and characteristics. For both factor models, characteristic pure plays generally have positive alphas, and covariance pure plays have negative alphas. The models fail especially in explaining returns to investment and when pure plays are momentum-neutral. The rejections are economically significant.

Keywords: factor pricing models, characteristics, Fama-Macbeth, errors-in-variables

JEL Classification: G11, G12

Suggested Citation

Back, Kerry and Kapadia, Nishad and Ostdiek, Barbara, Testing Factor Models on Characteristic and Covariance Pure Plays (July 16, 2015). Available at SSRN: https://ssrn.com/abstract=2621696 or http://dx.doi.org/10.2139/ssrn.2621696

Kerry Back (Contact Author)

Rice University - Jones Graduate School of Business and Department of Economics ( email )

6100 South Main Street
P.O. Box 1892
Houston, TX 77005-1892
United States

Nishad Kapadia

Tulane University - A.B. Freeman School of Business ( email )

A.B. Freeman School of Business
7 McAlister Drive
New Orleans, LA 70118
United States
504-314-7454 (Phone)

Barbara Ostdiek

Rice University - Jesse H. Jones Graduate School of Business ( email )

6100 South Main Street
P.O. Box 1892
Houston, TX 77005-1892
United States
713-348-5384 (Phone)
713-348-5251 (Fax)

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