Testing for Alpha in Linear Factor Pricing Models with a Large Number of Securities

100 Pages Posted: 24 May 2017

See all articles by M. Hashem Pesaran

M. Hashem Pesaran

University of Southern California - Department of Economics; University of Cambridge - Trinity College (Cambridge)

Takashi Yamagata

University of York - Department of Economics and Related Studies; Osaka University - Institute of Social and Economic Research

Multiple version iconThere are 2 versions of this paper

Date Written: April 24, 2017

Abstract

This paper proposes a novel test of zero pricing errors for the linear factor pricing model when the number of securities, N, can be large relative to the time dimension, T, of the return series. The test is based on Student t tests of individual securities and has a number of advantages over the existing standardised Wald type tests. It allows for non-Gaussianity and general forms of weakly cross correlated errors. It does not require estimation of an invertible error covariance matrix, it is much faster to implement, and is valid even if N is much larger than T. Monte Carlo evidence shows that the proposed test performs remarkably well even when T = 60 and N = 5;000. The test is applied to monthly returns on securities in the S&P 500 at the end of each month in real time, using rolling windows of size 60. Statistically significant evidence against Sharpe-Lintner CAPM and Fama-French three factor models are found mainly during the recent financial crisis. Also we find a significant negative correlation between a twelve-months moving average p-values of the test and excess returns of long/short equity strategies (relative to the return on S&P 500) over the period November 1994 to June 2015, suggesting that abnormal profits are earned during episodes of market inefficiencies.

Keywords: CAPM, testing for alpha, weak and spatial error cross-sectional dependence, S&P 500 securities, long/short equity strategy

JEL Classification: C120, C150, C230, G110, G120

Suggested Citation

Pesaran, M. Hashem and Yamagata, Takashi, Testing for Alpha in Linear Factor Pricing Models with a Large Number of Securities (April 24, 2017). CESifo Working Paper Series No. 6432, Available at SSRN: https://ssrn.com/abstract=2973079

M. Hashem Pesaran (Contact Author)

University of Southern California - Department of Economics

3620 South Vermont Ave. Kaprielian (KAP) Hall 300
Los Angeles, CA 90089
United States

University of Cambridge - Trinity College (Cambridge) ( email )

United Kingdom

Takashi Yamagata

University of York - Department of Economics and Related Studies ( email )

Heslington
York, YO1 5DD
United Kingdom

Osaka University - Institute of Social and Economic Research ( email )

6-1, Mihogaoka
Suita, Osaka 567-0047
Japan

Do you have a job opening that you would like to promote on SSRN?

Paper statistics

Downloads
147
Abstract Views
895
rank
125,403
PlumX Metrics