Pricing Model Performance And The Two-pass Cross-sectional Regression Methodology

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Executive Summary

Statistical inference with this method is typically conducted under the assumption that the models are correctly specified, i.e., expected returns are exactly linear in asset betas. This can be a problem in practice since all models are, at best, approximations of reality and are likely to be subject to a certain degree of misspecification. The authors propose a general methodology for computing misspecification robust asymptotic standard errors of the risk premia estimates. They also derive the asymptotic distribution of the sample CSR R2 and develop a test of whether two competing beta pricing models have the same population R2.

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