Assessing Asset Pricing Model Misspecification with a Returns Decomposition

48 Pages Posted: 6 Dec 2001

Date Written: November 28, 2001

Abstract

Asset returns implicitly contain information about the systematic and nonsystematic risks in an economy. Based solely on the law of one price condition, we extract this information by using a mean-variance frontier decomposition of returns, and exploit it to improve the assessment of specification errors of stochastic discount factor models. Our empirical results document a large and significant mispricing of both the systematic and nonsystematic risks in industry returns, even for models not rejected by a test of over-identifying restrictions. Furthermore, models with smaller pricing errors on the pervasive portion of returns generally obtain larger pricing errors on the idiosyncratic portion of returns. We explain why this tradeoff is likely to occur and how it affects the evaluation of asset pricing models.

Keywords: asset pricing, idiosyncratic risk, model evaluation

JEL Classification: G12

Suggested Citation

Chrétien, Stéphane and Cliff, Michael T., Assessing Asset Pricing Model Misspecification with a Returns Decomposition (November 28, 2001). Twelfth Annual Utah Winter Finance Conference. Available at SSRN: https://ssrn.com/abstract=292419 or http://dx.doi.org/10.2139/ssrn.292419

Stéphane Chrétien

Université Laval ( email )

Pavillon Palasis-Prince
2325, rue de la Terrasse
Quebec City, Quebec G1V 0A6
Canada
418-656-2131 x3380 (Phone)

Michael T. Cliff (Contact Author)

Analysis Group ( email )

800 17th St, N.W.
Suite 400
Washington, DC 20006
United States
(202) 530-2010 (Phone)

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