Working Paper: NBER ID: w7661
Authors: Robert J. Hodrick; Xiaoyan Zhang
Abstract: This paper examines the specification errors of several asset pricing models using the methodology of Hansen and Jagannathan (1997) and a common data set. The models are the CAPM, the Consumption CAPM, the Jagannathan and Wang (1996) conditional CAPM, the Campbell (1996) dynamic asset pricing model, the Cochrane (1996) production-based model, and the Fama-French (1993) three-factor and five-factor models. We use returns on the Fama-French twenty-five portfolios sorted by size and book-to-market ratio and the risk-free rate as our test assets. The sample is 1952 to 1997. We allow the parameters of the models' pricing kernels to fluctuate with the business cycle which we measure in two ways. One uses the Hodrick-Prescott (1997) filter applied to either industrial production for monthly models or real GNP for quarterly models. The second approach for quarterly models uses the consumption-wealth measure developed by Lettau and Ludvigson (1999). While we cannot reject correct pricing for Campbell's model, a stability test indicates that the parameters may not be stable. None of the models correctly prices returns that are scaled by the term premium.
Keywords: No keywords provided
JEL Codes: G10; E21
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| CAPM (O22) | expected return anomalies (G14) |
| expected return prediction of CAPM (G17) | relationship between asset returns and market portfolio returns (G17) |
| empirical CCAPM fails to predict returns correctly (C59) | expected returns depend on covariance of returns with marginal utility of consumption (D11) |
| dynamic asset pricing model and production-based model do not consistently price returns scaled by term premium (G19) | systematic failure across models (C52) |
| Campbell model cannot be rejected for correct pricing (G13) | parameters may not be stable (C62) |
| time-varying risk premiums (G19) | asset pricing (G19) |
| instability of model parameters over time (C22) | incorrect conclusions about model validity (C52) |