Empirical tests of asset pricing models with individual assets: Resolving the errors-in-variables bias in risk premium estimation

To attenuate an inherent errors-in-variables bias, portfolios are widely employed to test asset pricing models; but portfolios might mask relevant risk- or return-related features of individual stocks. We propose an instrumental variables approach that allows the use of individual stocks as test ass...

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Bibliographic Details
Published in:Journal of financial economics 2019-08, Vol.133 (2), p.273-298
Main Authors: Jegadeesh, Narasimhan, Noh, Joonki, Pukthuanthong, Kuntara, Roll, Richard, Wang, Junbo
Format: Article
Language:English
Subjects:
Asset pricing
Asset pricing models
Assets
Bias
Capital assets
CAPM
Economic models
Errors-in-variables bias
Five factor model
Individual stocks
Instrumental variables
Portfolios
Premiums
Pricing policies
Risk factors
Risk premium estimation
Risk premiums
Variables
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Summary:To attenuate an inherent errors-in-variables bias, portfolios are widely employed to test asset pricing models; but portfolios might mask relevant risk- or return-related features of individual stocks. We propose an instrumental variables approach that allows the use of individual stocks as test assets, yet delivers consistent estimates of ex post risk premiums. This estimator also yields well-specified tests in small samples. The market risk premium under the capital asset pricing model (CAPM) and the liquidity-adjusted CAPM, premiums on risk factors under the Fama–French three- and five-factor models, and the Hou et al. (2015) four-factor model are all insignificant after controlling for asset characteristics.
ISSN:0304-405X
1879-2774
DOI:10.1016/j.jfineco.2019.02.010