Empirical Tests of Asset Pricing Models with Individual Assets: Resolving the Errors-in-Variables Bias in Risk Premium Estimation

67 Pages Posted: 24 Sep 2015

See all articles by Narasimhan Jegadeesh

Narasimhan Jegadeesh

Emory University - Department of Finance

Joonki Noh

Case Western Reserve University - Department of Banking and Finance

Kuntara Pukthuanthong

University of Missouri, Columbia

Richard Roll

California Institute of Technology

Junbo L. Wang

Louisiana State University, Baton Rouge

Multiple version iconThere are 2 versions of this paper

Date Written: September 22, 2015

Abstract

To attenuate an inherent errors-in-variables bias, portfolios are widely employed for risk premium estimation; but portfolios might diversify away and thus mask relevant risk- or return-related features of individual assets. We propose a resolution that allows the use of individual assets while avoiding the bias. It hinges on specific instrumental variables, factor sensitivities (β’s) calculated from alternate observations. Closed-form asymptotics are provided for large cross-sections and time-series. Simulations indicate that the IV method delivers unbiased risk premium estimates and well-specified tests with adequate power in small samples. Empirical implementation finds some evidence of significant risk premiums for the size and book-to-market. However, when controlling for non-β characteristics, estimated risk premiums are insignificant for the CAPM, size, book-to-market, investments, profitability, and the liquidity-adjusted CAPM.

Keywords: Risk Premium Estimation, Errors-in-Variables Bias, Instrumental Variables, Individual Stocks, Asset Pricing Models

JEL Classification: G12, C10

Suggested Citation

Jegadeesh, Narasimhan and Noh, Joonki and Pukthuanthong, Kuntara and Roll, Richard W. and Wang, Junbo L., Empirical Tests of Asset Pricing Models with Individual Assets: Resolving the Errors-in-Variables Bias in Risk Premium Estimation (September 22, 2015). Available at SSRN: https://ssrn.com/abstract=2664332 or http://dx.doi.org/10.2139/ssrn.2664332

Narasimhan Jegadeesh

Emory University - Department of Finance ( email )

Atlanta, GA 30322-2710
United States

Joonki Noh (Contact Author)

Case Western Reserve University - Department of Banking and Finance ( email )

10900 Euclid Ave.
Cleveland, OH 44106-7235
United States
216-368-3737 (Phone)

Kuntara Pukthuanthong

University of Missouri, Columbia ( email )

Robert J. Trulaske, Sr. College of Business
403 Cornell Hall
Columbia, MO 65211
United States
6198076124 (Phone)

HOME PAGE: http://https://kuntara.weebly.com

Richard W. Roll

California Institute of Technology ( email )

1200 East California Blvd
Mail Code: 228-77
Pasadena, CA 91125
United States
626-395-3890 (Phone)
310-836-3532 (Fax)

Junbo L. Wang

Louisiana State University, Baton Rouge ( email )

Baton Rouge, LA 70803
United States

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