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Testing Conditional Asset Pricing Models Using a Markov Chain Monte Carlo Approach

41 Pages Posted: 2 Mar 2005 Last revised: 26 Mar 2014

Manuel Ammann

University of St. Gallen - School of Finance

Michael Verhofen

University of St. Gallen - Swiss Institute of Banking and Finance; Allianz Global Investors

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Date Written: December, 16th 2004

Abstract

We propose a new approach for the estimation of conditional asset pricing models based on a Markov Chain Monte Carlo (MCMC) approach. In contrast to existing approaches, it is truly conditional because the assumption that time variation in betas is driven by a set of conditioning variables is not necessary. Moreover, the approach has exact finite sample properties and accounts for errors-in-variables in a one-step estimation procedure. Using S&P 500 panel data, we analyze the empirical performance of the CAPM and the Fama and French (1993) three-factor model. We find that time-variation of betas in the CAPM and the time variation of the coefficients for the size factor (SMB) and the distress factor (HML) in the three-factor model improve the empirical performance by a similar amount. Therefore, our findings are consistent with time variation of firm-specific exposure to market risk, systematic credit risk and systematic size effects. However, a Bayesian model comparison trading off goodness of fit and model complexity indicates that the conditional CAPM performs best, followed by the conditional three-factor model, the unconditional CAPM, and the unconditional three-factor model.

JEL Classification: G12

Suggested Citation

Ammann, Manuel and Verhofen, Michael, Testing Conditional Asset Pricing Models Using a Markov Chain Monte Carlo Approach (December, 16th 2004). Available at SSRN: https://ssrn.com/abstract=673501 or http://dx.doi.org/10.2139/ssrn.673501

Manuel Ammann

University of St. Gallen - School of Finance ( email )

Unterer Graben 21
St.Gallen, CH-9000
Switzerland

Michael Verhofen (Contact Author)

Allianz Global Investors ( email )

Frankfurt
Germany

University of St. Gallen - Swiss Institute of Banking and Finance ( email )

Rosenbergstrasse 52
St. Gallen, CH-9000
Switzerland

HOME PAGE: http://www.verhofen.com

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