A Skeptical Appraisal of Asset Pricing Tests
44 Pages Posted: 17 Mar 2006 Last revised: 24 Feb 2009
Date Written: May 1, 2008
It has become standard practice in the cross-sectional asset-pricing literature to evaluate models based on how well they explain average returns on size-B/M portfolios, something many models seem to do remarkably well. In this paper, we review and critique the empirical methods used in the literature. We argue that asset-pricing tests are often highly misleading, in the sense that apparently strong explanatory power (high cross-sectional R2s and small pricing errors) in fact provides quite weak support for a model. We offer a number of suggestions for improving empirical tests and evidence that several proposed models don't work as well as originally advertised.
Keywords: asset pricing tests, stock returns, cross section
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