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Two‐Pass Tests of Asset Pricing Models with Useless Factors

Two‐Pass Tests of Asset Pricing Models with Useless Factors In this paper we investigate the properties of the standard two‐pass methodology of testing beta pricing models with misspecified factors. In a setting where a factor is useless, defined as being independent of all the asset returns, we provide theoretical results and simulation evidence that the second‐pass cross‐sectional regression tends to find the beta risk of the useless factor priced more often than it should. More surprisingly, this misspecification bias exacerbates when the number of time series observations increases. Possible ways of detecting useless factors are also examined. http://www.deepdyve.com/assets/images/DeepDyve-Logo-lg.png The Journal of Finance Wiley

Two‐Pass Tests of Asset Pricing Models with Useless Factors

The Journal of Finance , Volume 54 (1) – Feb 1, 1999

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References (32)

Publisher
Wiley
Copyright
© American Finance Association
ISSN
0022-1082
eISSN
1540-6261
DOI
10.1111/0022-1082.00102
Publisher site
See Article on Publisher Site

Abstract

In this paper we investigate the properties of the standard two‐pass methodology of testing beta pricing models with misspecified factors. In a setting where a factor is useless, defined as being independent of all the asset returns, we provide theoretical results and simulation evidence that the second‐pass cross‐sectional regression tends to find the beta risk of the useless factor priced more often than it should. More surprisingly, this misspecification bias exacerbates when the number of time series observations increases. Possible ways of detecting useless factors are also examined.

Journal

The Journal of FinanceWiley

Published: Feb 1, 1999

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