MCFAM Seminar - Estimating and Testing Investment-based Asset Pricing Models

Speaker: Yao Deng

Abstract: The standard investment-based asset pricing model predicts that stock returns equal investment returns, state-by-state. Yet, typical work in asset pricing only tests the weaker prediction that stock returns and investment returns should be equal on average. We document that by following the traditional methodology of only matching mean moments to estimate the model, most of the time series variation of stock returns is captured by the error terms, not by the predicted investment returns. We then show how to incorporate the model-implied time series restrictions in the estimation and testing of the model using the generalized method of moments, and formulate an external validity specification test. Our method uncovers a tradeoff between cross sectional fit and time series fit: the baseline investment-based model cannot fit both sets of moments simultaneously. Simulation exercises show that our estimation approach improves the power of the standard tests to detect model misspecification, and hence can be useful for improving the specification of future investment-based asset pricing models.