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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 (2018) Too good to be true? Fallacies in evaluating risk factor models. Journal of Financial Economics . doi:10.1016/j.jfineco.2018.10.012 (In Press)

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Official URL: https://doi.org/10.1016/j.jfineco.2018.10.012

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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
Subjects: H Social Sciences > HG Finance
Divisions: Faculty of Social Sciences > Warwick Business School > Finance Group
Faculty of Social Sciences > Warwick Business School
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: 27 October 2018
Dates:
DateEvent
27 October 2018Available
16 February 2018Accepted
Date of first compliant deposit: 9 July 2018
DOI: 10.1016/j.jfineco.2018.10.012
Status: Peer Reviewed
Publication Status: In Press
Access rights to Published version: Restricted or Subscription Access
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