Working Paper: CEPR ID: DP13365
Authors: Mikhail Chernov; Lars Lochstoer; Stig Lundeby
Abstract: We propose testing asset-pricing models using multi-horizon returns (MHR). MHR effectively generate a new set of test assets that are endogenous to the model and that identify a broad set of possible conditional misspecifications. We apply MHR-based testing to prominent linear factor models and show that these models typically do a poor job of pricing longer-horizon returns, with pricing errors of similar magnitude as the risk premiums they were designed to explain. We trace the errors to the conditional factor dynamics. Explicitly incorporating factor timing in the models often makes mispricing worse, posing a challenge for future research.
Keywords: multihorizon returns; stochastic discount factor; linear factor models
JEL Codes: G12; C51
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Traditional linear factor models (C38) | Poor performance in pricing longer-horizon returns (G19) |
| Conditional dynamics of factors (C69) | Pricing errors (D49) |
| Factor timing incorporation (D25) | Exacerbation of mispricing (G19) |
| Models are rejected (C52) | Fail to price factors conditionally (L11) |