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Too good to be true? Fallacies in evaluating risk factor models
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Gospodinov, Nikolay, Kan, Raymond and Robotti, Cesare (2019) Too good to be true? Fallacies in evaluating risk factor models. Journal of Financial Economics, 132 (2). pp. 451-471. doi:10.1016/j.jfineco.2018.10.012
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Official URL: https://doi.org/10.1016/j.jfineco.2018.10.012
Abstract
This paper is concerned with statistical inference and model evaluation in possibly misspecified and unidentified linear asset-pricing models estimated by maximum likelihood. Strikingly, when spurious factors (that is, factors that are uncorrelated with the returns on the test assets) are present, the models exhibit perfect fit, as measured by the squared correlation between the model's fitted expected returns and the average realized returns. Furthermore, factors that are spurious are selected with high probability, while factors that are useful are driven out of the model. While ignoring potential misspecification and lack of identification can be very problematic for models with macroeconomic factors, empirical specifications with traded factors (e.g., Fama and French, 1993, and Hou, Xue, and Zhang, 2015) do not suffer of the identification problems documented in this study.
| Item Type: | Journal Article | ||||||||
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| Subjects: | H Social Sciences > HG Finance | ||||||||
| Divisions: | Faculty of Social Sciences > Warwick Business School > Finance Group Faculty of Social Sciences > Warwick Business School |
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| Library of Congress Subject Headings (LCSH): | Capital assets pricing model, Capital -- Mathematical models | ||||||||
| Journal or Publication Title: | Journal of Financial Economics | ||||||||
| Publisher: | Elsevier Science BV | ||||||||
| ISSN: | 0304-405X | ||||||||
| Official Date: | May 2019 | ||||||||
| Dates: |
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| Volume: | 132 | ||||||||
| Number: | 2 | ||||||||
| Page Range: | pp. 451-471 | ||||||||
| DOI: | 10.1016/j.jfineco.2018.10.012 | ||||||||
| Status: | Peer Reviewed | ||||||||
| Publication Status: | Published | ||||||||
| Access rights to Published version: | Restricted or Subscription Access | ||||||||
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| Open Access Version: |
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