Testing Asset Pricing Models on Individual Stocks

Abstract

This paper tests asset pricing models using individual stocks as test assets, rather than sorted portfolios. Sorted portfolios have the severe limitation that the researcher must know, in advance, reliable predictors of expected returns. We show how to generate appropriately sized tests and verify that our tests have considerable test power. We apply our tests to seven leading factor models. We reject six of the seven leading models we test. The instrumented factor model of Kelly, Pruitt, and Su stands out as the most successful. We show a natural extension of our approach incorporates characteristic driven time-variation in factor loadings.

Keywords: Empirical Asset Pricing

JEL Classification: G12, C15