Journal of Banking & Finance 36 (2012) 10571066

Contents lists available at SciVerse ScienceDirect

Journal of Banking & Finance

journal homepage: www.elsevier.com/locate/jbf

The performance of cross-sectional regression tests of the CAPM with

non-zero pricing errors
Irina Murtazashvili a, Nadia Vozlyublennaia b,
a
Department of Economics, University of Pittsburgh, Pittsburgh, PA 15260, United States
b
Area of Finance, Rawls College of Business Administration, Texas Tech University, Lubbock, TX 79409-2101, United States

a r t i c l e i n f o a b s t r a c t

Article history: We show that in the presence of non-zero pricing errors, the FamaMacBeth (FM) cross-sectional regres-
Received 28 September 2010 sion test is very likely to either reject the Capital Asset Pricing Model (CAPM) when it (almost) holds or
Accepted 23 October 2011 accept the model when it grossly fails. We investigate the case when pricing errors are correlated with
Available online 28 October 2011
betas and demonstrate that the test performance depends crucially on the correlation, cross-sectional
distribution of betas, and several other parameter values. Even when the CAPM holds exactly (pricing
JEL classication: errors are zero) the FM test is equally likely to either reject or accept the model when typical sample sizes
G10
are used.
G12
2011 Elsevier B.V. All rights reserved.
Keywords:
CAPM
FamaMacBeth procedure
Pricing errors

1. Introduction
A cross-sectional regression-based (CSR-based) method of test-
ing asset pricing models, as developed in Black et al. (1972) and
Fama and MacBeth (1973), has been extensively used in nancial
research.1 Most of the studies, which examine the properties of this
test rely on the assumption that pricing errors (deviations from the
Security Market Line, also called alphas) are zero.2 In this paper we
examine the impact of this assumption on the power of the CSR-
based test as implemented by Fama and MacBeth (1973). We show
that in the presence of non-zero pricing errors, the FamaMacBeth
(FM) test is very likely to either reject the CAPM when it (almost)
holds or accept the model when it grossly fails. Moreover, our sim-
ulations show that when the CAPM holds exactly the FM test rejects
the true null in about 50% of cases (in a typical sample of ve years of
monthly data).
Corresponding author. Tel.: +1 806 742 3377; fax: +1 806 742 3197.
E-mail addresses: irinam@pitt.edu (I. Murtazashvili), nadia.vozlyublennaia@t-
tu.edu (N. Vozlyublennaia).
1 4
Although originally designed to address asset pricing questions, this two-step
procedure has now been applied in other areas, as well. See, for example, Fama and
French (1998) and Grinstein and Michaely (2005).
2
Including, but not limited to, Shanken (1992), Jagannathan and Wang (1998), Roll
and Ross (1994), Kan and Zhang (1999), Kim (1995), Grinstein and Michaely (2005),
and Connolly and Rendleman (2007).
There is a well-known bias in the CSR when pricing errors are
correlated with betas.3 However, analytically the bias is ambiguous
on the power of CSR-based tests. To assess the extent of a CSR-based
tests failure in the presence of the bias we compare CSR-based test
performance using the FamaMacBeth method to that of the multi-
variate time-series regression (TSR) based test of Gibbons et al.
(1989) (GRS test) in simulations.4 We nd the difference in the tests
predictions about the CAPM can be substantial. Overall, the simula-
tion results suggest that the GRS test has reasonable size and power
properties, i.e., it successfully rejects the CAPM when pricing errors
are large, and it fails to reject the CAPM when pricing errors are
small. Alternatively, the FM (CSR-based) test, is subject to Type I5
or Type II errors in most cases.
We pay special attention to two cases: (1) when the bias is sub-
stantial, while pricing errors are small relative to the variation in
returns (i.e. the CAPM almost holds), and (2) when the bias is small,
while pricing errors are large (the CAPM fails). If pricing errors are
small (the CAPM almost holds), but negatively correlated with be-
tas, a negative bias decreases the magnitude of the coefcient on
3
See Black et al. (1972) for a relevant discussion.
We want to emphasize that our results do not advocate the GRS test, which has
certain caveats of its own (see Cochrane, 2001 for a summarizing discussion). We only
use the GRS test as a popular alternative to CSR-based tests to highlight the issues in
CSRs.
5
Strictly speaking we have the case of Type I like error since the null hypothesis
is rejected when it is nearly true. We will refer to this situation as Type I for simplicity.

0378-4266/$ - see front matter 2011 Elsevier B.V. All rights reserved.
doi:10.1016/j.jbankn.2011.10.018
1058 I. Murtazashvili, N. Vozlyublennaia / Journal of Banking & Finance 36 (2012) 10571066

beta in the CSR. The FM test is less likely to reject the null that beta cates a TSR-based procedure of testing multi-beta models with
coefcient is zero, leading to the conclusion that betas are not sig- non-traded factors in place of the more traditional CSR-based tests.
nicantly related to the cross-section of returns (the CAPM fails). If The second study discusses difculties introduced by the presence
pricing errors are large (the CAPM fails), but positively correlated of pricing errors in the estimation of the risk premium of factors,
with betas, a substantial positive bias increases the cross-sectional which are not spanned by returns. Hou and Kimmel (2006) recom-
coefcient on beta. The FM test is more likely to reject the null that mend projecting these factors on the time-series of returns. Both of
beta coefcient is zero, leading to an incorrect conclusion that be- these studies consider the case when risk factors are not returns.
tas are signicantly related to the cross-section of returns (the We, on the other hand, concentrate on the case when factors are
CAPM is valid). The difference in the probability to reject the CAPM returns on benchmark portfolios, and investigate how the proper-
based on the FM and GRS tests vary substantially depending on the ties of the pricing errors (such as their magnitude and correlation
specic values of the parameters and can be either very small with betas) determine the power of CSR tests.
(0.2%) or very large (over 90%).
We perform robustness tests with sample-estimated betas, dif- 3. Theoretical discussion
ferent means and covariance matrices of returns, equally-weighted
and value-weighted betas, 25 and six portfolios of stocks, and dif- We discuss rst possible reasons for weak performance of CSR-
ferent time dimensions. Although the results imply that the FM based methods (such as the FM test) in the presence of non-zero
test is very likely subject to Type I or II error in all of these cases, pricing errors. Since a CSR test is a two-step procedure, a clear view
without knowing all the parameter values it is hard to predict of the test-related issues can be obtained when both steps are
the probability of an error. Moreover, correctly assessing these combined into one equation. We conclude this section by isolating
parameters in practice is very problematic. several specic issues, which we address in the subsequent
The paper is structured as follows. Section 2 contains relevant simulations.
literature. Section 3 presents theoretical discussion. Section 4 de- Let us consider one risk factor (ft, an excess return on a bench-
scribes the simulation algorithm. Section 5 talks about the simula- mark portfolio) for simplicity.6 Suppose the excess return (R) on
tion results. Section 6 concludes. asset i at time t is generated by the following process:
Rit ai bi ft uit ; 1
2. Related literature
where ai is a pricing error of asset i, uit is a random error for that
asset at time t. Assume an N  1 vector ut = (u1t, u2t, . . . , uNt)0 follows
We examine the impact on CSR-based tests of the bias that ex-
a (time-series) distribution with mean zero and an N  N covariance
ists when pricing errors are correlated with betas. Clearly, our anal-
matrix V. Here uit are assumed to be uncorrelated across t and
ysis requires relaxing the standard assumption in the literature of
across i (i.e., V is diagonal).7 The FM test is based on the following
zero pricing errors. There is a limited literature, which examines
CSR at time t:
properties of CSR-based tests under the assumption of non-zero
pricing errors and these papers primarily focus on population Rit c0t c1t bi eit ; 2
parameters under zero versus non-zero pricing errors. We briey
where bi is the slope coefcient from population model (1), and eit is
review this literature in this section.
an error term. Suppose time-series data for factor ft are used to esti-
The basic consensus of this literature is that the conclusions
mate betas in the rst stage. Then, ignoring the errors-in-variables
based on the parameters of a CSR-based test are neither necessary
problem due to estimation of betas, the coefcient on beta in a
nor sufcient to decide whether the asset pricing model holds.
cross-sectional regression of Rit on (perfectly estimated) bi at time
Kandel and Stambaugh (1995), for example, reveals an important
t is:
problem with the CSR-based tests when the CAPM mis-pricing is
P
present, specically, the R2 from a CSR can be unrelated to the de-  1Rit  Rt
i bi
gree of efciency of the market portfolio. This issue can be resolved c^1t P 2
i bi  1
by implementing a generalized least squares (GLS) regression with P
the original time-series covariance matrix of returns as a weighting  1ai bi  1ft uit  u
i bi
t
P 2
matrix. Another example is a study by Grauer (1999), which shows i b i  1
P P
that the CAPM may appear to be true according to a CSR test when i ai bi

i bi  1uit  ut
in fact it is false if pricing errors are orthogonal to betas, market P 2
f t P 2
; 3
i bi  1 i bi  1
weights and the vector of ones. P
Rit P P 8
Several studies investigate the power of CSR-based tests in sim- where Rt Ni ; i bi N, and i ai 0; i 1; . . . ; N. Following
ulations. Grauer and Janmaat (2009) demonstrate that the statisti- the FM procedure, let us consider a t-test of the mean of c ^1t . When
cal power of CSR-based tests of the CAPM against the alternative of pricing errors are non-zero, the rst term in the above expression
the FamaFrench three-factor model is very low. Shanken and is non-zero. Moreover, when pricing errors are correlated with betas,
Zhou (2007) derive a general asymptotic distribution of CSR-based this term does not vanish asymptotically. We will refer to it as a
methods under model mis-specication. Their analytical results bias.
and simulation evidence suggest that the presence of mis-pricing The last term in Eq. (3) depends on the cross-sectional distribu-
increases standard errors. Moreover, the extent of the increase of tion of beta. If betas are symmetrically centered around 1 then this
the standard errors depends on the values of several parameters. term is close to zero if uits are independent across i.9 Assuming that
While the authors do not explicitly address issues related to the
correlation of pricing errors and betas, they do note that it could 6
The derivations for the case of multiple risk factors are given in the Appendix.
drive some of their simulation results. Shanken and Zhou (2007) 7
Even though this assumption can be somewhat relaxed, we adopt one of the more
conclude that mis-pricing may lead to certain concerns, including typical settings.
8
Pricing errors sum to zero and betas sum to N since our risk factor is a simple
incorrect inference.
average return across securities.
Other papers, which investigate performance of the CSR-based 9
By the (weak) law of large numbers for a large number of iid assets the average of
methods under model mis-specication include Balduzzi and the numerator converges to zero. Therefore, the whole ratio converges to zero
Robotti (2008) and Hou and Kimmel (2006). The rst study advo- assuming that the cross-sectional variance of beta is a nite number.
 I. Murtazashvili, N. Vozlyublennaia / Journal of Banking & Finance 36 (2012) 10571066
the rst and last terms in Eq. (3) are zero, the FM statistic is based on
the time-series of the risk factor (ft), even if ft is irrelevant to returns.
Similarly, Kan and Zhang (1999) demonstrate that an irrelevant risk
factor may lead to a large FM t-test when betas have to be estimated
in the rst stage.
In reality, though, both the rst and last terms in Eq. (3) are
present and likely substantial. Even though both of these terms
may create distortions in the test, it is not clear if it is desirable
to dispose of them since they contain relevant information on pric-
ing errors and random errors (uit, which determine how (statisti-
cally) large pricing errors are).
The effect of the rst term (the bias) on the conclusion from the
FM test can be ambiguous. When pricing errors are large and neg-
atively correlated with betas, a negative bias occurs, decreasing the
FM statistic, resulting in the (correct) conclusion that the model
fails, i.e. the factor is irrelevant to returns. This effect is not purely
random, since large pricing errors are likely to be associated with a
large bias. Alternatively, if pricing errors are substantial and posi-
tively correlated with betas, a large positive bias increases the
FM statistic. In this case we are likely to (incorrectly) conclude that
the risk factor is relevant and the model is valid. The goal of this
study is to systematically examine the impact of the bias on the
power of the FM test. Next, we discuss the design of our
simulations.
4. Simulation algorithm
In this section we discuss the details of our simulation
approach. We assume an economy with an iid vector of stock re-
turns, which follows a joint Normal distribution with a specied
vector of means and a covariance matrix.10 We consider the stan-
dard one-factor model (the CAPM). We take the covariance matrix
as xed and adjust the vector of means in order to control the pricing
errors and the bias (cross-sectional correlation between pricing er-
rors and betas). We are interested in the relative performance of
the FM test versus the GRS test.
Let us assume that assets excess returns in period t (dened by
an N  1 vector Rt) are generated as a random draw from a joint
Normal distribution with an N  1 mean vector l and an N  N
covariance matrix V. In our analysis that follows we take V as given
(estimated on data). For our basic setup we estimate V on monthly
data of N = 25 equally-weighted portfolio excess returns sorted on
book-to-market and size for the period of 20032007. The returns
data are obtained from K. Frenchs web page.11 Since the OLS CSR-
based test should perform better with equal weights, we use equal
weighting in the basic set up to highlight the fact that even under
such preferred conditions the test performance is poor. Later we
conduct a robustness check with value weights.
We model pricing errors as linear functions of betas plus errors:
ai u ubi fi : 4 mates of the vector a and covariance matrix of N = N  1 assets (V)
10
Our approach is not typical to the literature (except for Connolly and Rendleman
(2007), and Grauer and Janmaat (2009)), since we simulate returns out of a joint
distribution with parameters, which are in line with the CAPM. Typically the returns
are simulated as a function of a time series of the risk factor. The advantage of our
approach is a better control over the parameters of the CAPM.
11
The main reason for simulating 25 portfolio returns is that this setup is typically
used in the FM test. We could have used individual security returns for the GRS test
and combine these returns into portfolios for the FM test, but it would take us away
from assessing the differences in the GRS and FM tests. Portfolios pricing errors and
individual stocks pricing errors are quite different, so the results of the two tests are
not directly comparable. We do not address any issues related to portfolio formation
either, since one of the major reasons for doing so (as indicated in Fama and MacBeth
(1973)) is the reduction of estimation errors in betas. Given that betas are known in
our simulations, forming portfolios or using individual assets will not make a
difference.
1059
In this equation ai is the pricing error of asset i, u is the bias, i.e. the
coefcient in the cross-sectional relationship between pricing error
and beta, bi is the ith element of an N  1 vector b = (w0 Vw)1Vw,
where w is an N  1 vector of weights. Finally, fi is the random
error, which represents the part of pricing error unrelated to beta.
We generate fi from a Normal distribution with zero mean and var-
iance r2f . Given the total number of assets N, we create N  1 pricing
errors using the above equation and adjust the remaining pricing
error to ensure that pricing errors sum to zero across assets.12
The pricing errors (a), therefore, consist of two parts: random
noise (f), and betas. Thus, we can increase pricing errors in abso-
lute value simply by raising r2f . However, a small r2f does not guar-
antee pricing errors close to zero, because they also depend on
betas (determined by the covariance matrix V) and on the param-
eter u. So, variation of pricing errors is limited by the values of
these parameters.
Given the vector a generated as described above, we proceed by
computing the vector of means l from the CAPM equation as:
li ai l bi ; 5
where l is the market risk premium. For most of our simulations
we set l to be a simple average of monthly excess returns across
both time and portfolios for period 20032007. Plugging (4) into
(5) we obtain the following equation for the mean of asset i:
li u l ubi fi : 6
We model the returns as the above mean (li) plus a random er-
ror (uit):
Rit ai bi l uit : 7
0
Vector ut = (u1t, u2t, . . . , u25t) , where t = 1, . . ., 60, is distributed as a
multivariate Normal with mean zero and covariance matrix V.
The FM t statistic c ^1t is obtained by regressing Rit on bi for each
month. Betas are computed directly from matrix V since we focus
in this paper on the issues unrelated to the estimation of betas
and therefore use the known betas in the CSR.13 The FM statistic
is calculated in each replication as follows:
c^1
t  p ; 8
sc
^1t = T
where c 
^1 is the sample average of c 
^1t and sc
^1t is its standard devi-
ation. We repeat the process 500 times and report the percentage of
replications where the test rejects/accepts the null hypothesis that
c1 equals some specied value at the 5% level.
To obtain a GRS statistic we run the following TSR for each asset
i:
Rit ai bi Rt uit ; 9
where Rt is the average return across N assets in each month. Esti-
are used to form the GRS test statistic as follows:14
0 !2 11
T  N  1 @ R A a b 1 a
J 1 ^0 V ^; 10
N r^ R
t
12
We impose this requirement on the generated pricing errors to match the
corresponding property of the true pricing errors when the Market Portfolio is
equally weighted. Eq. (4) is also structured in such a way that the cross-sectional
expected value of pricing error is zero, i.e. mis-pricing is zero on average. An
alternative is to choose the intercept in Eq. (4) as a number (M) other than u. The
expected value of ai in this case is M + u 0, given that the expected value of beta is
one in our set up. However, this does not affect the slope in the CSR.
13
We run a robustness test later where we use sample-estimated betas and show
that the results are not signicantly affected.
14
We use only N  1 assets in the test, since the covariance matrix of N assets is
singular.
1060 I. Murtazashvili, N. Vozlyublennaia / Journal of Banking & Finance 36 (2012) 10571066

where R is the estimated average equally-weighted market portfolio Table 1

return,15 r
^ R is the maximum likelihood estimate of the market port-
t
b is the maximum likelihood estimate
folio standard deviation, and V
of the regression errors covariance matrix. The GRS test statistic is
distributed as F N ;TN 1 . As with the FM test we repeat the process
500 times and report the percentage of cases when the test rejects
the null hypothesis at the 5% level.
Let us now consider four scenarios, which arise from the inter-
section of the two following cases, each of which has two possible
outcomes: the CAPM (almost) holds (pricing errors are small) or
does not hold (pricing errors are large), and the FM test rejects or
fails to reject the model. Let us rst consider a situation when
the model (almost) holds. To create small pricing errors it is
enough to choose small u and r2f . In this scenario, the GRS test is
The GRS and the FamaMacBeth t-tests for various magnitudes of cross-sectional
regression bias and CAPM pricing errors. This table reports simulation results of the
GRS test and the FamaMacBeth (FM) t-test for 25 size and book-to-market sorted
portfolios. The number of runs is 500, the number of time periods in each run is 60
and 500. Returns are simulated from the joint Normal distribution with the
covariance matrix estimated on monthly data for portfolio returns in 20032007.
The average equally weighted market portfolio mean is estimated as 1.24, while each
portfolio mean is calibrated with parameters r2f and u. Column (1) is the bias. Column
(2) is the percent of all the replications where H0: a1 =    = aN1 = 0 is rejected by the
GRS test. Column (3) is the percent of all the replications where H0: c = l is rejected
by the FM t-test, while c is the slope coefcient from the regression of Ri on bi. Column
(4) is the percent of all the replications where H0: c = 0 is accepted by the FM t-test.
Columns 24 present the results for T = 60. Columns 57 have the same meaning as
Columns 24 except for T = 500.
u GRS60 FM60 GRS500 FM500

not expected to detect pricing errors. If u is set as a small positive H0: a = 0 H0: c = l H0: c = 0 H0 : a = 0 H0: c = l H0: c = 0
number the FM statistic is likely to reject the null that beta coef- (1) (2) (3) (4) (5) (6) (7)

cient is zero and conclude that the CAPM holds. If, on the other Panel A: r2f 0:01
hand, u is set as a small but negative number the FM test is likely 1.5 89 64.6 93 100 100 82.2
to conclude that the model fails. Now let us turn to a situation 1.24 70.8 48 95.2 100 100 98.2
1 43.4 33.4 93.8 100 99.8 75
when the model fails (i.e. the pricing errors are large). To model
0.6 13.4 15.8 83 100 76.4 16
this scenario it is sufcient to pick a large r2f . The GRS test is 0.3 5 7.4 70.6 59 23.4 0.6
expected to detect pricing errors and conclude that the CAPM fails, 0 2.8 4.8 52.8 3.2 1.8 0
while the performance of the FM test depends on the parameter u. 0.3 5.6 6.4 34.6 55.2 24.6 0
Therefore, by varying parameter values we should be able to pin- 0.6 13.4 15.6 20 100 78.8 0
1 47 32.6 7.6 100 99.8 0
point the cases when the FM statistic gives an incorrect conclusion 1.5 88.4 63 0.8 100 100 0
about the model. We then compare the performance of the FM test
in various scenarios to the performance of the GRS test. Panel B: r2f 0:05
1.5 93.4 64 93.2 100 100 80.2
1.24 78.6 48.6 95 100 100 98.4
1 64 33.4 93.8 100 99.8 82.2
5. Discussion of the simulation results
0.6 29.6 17 83.4 100 76.4 8
0.3 18 7 70.2 99.4 24.2 0.6
5.1. Main results 0 13.8 5 53 98.2 1.6 0
0.3 19.4 6.8 34.4 99.8 24.2 0
In this section we discuss the simulation results on sensitivity of 0.6 32 15.8 20.6 100 77 0
1 66.2 32.8 7.2 100 99.6 0
both the FM and GRS tests to parameters u and r2f . We set param- 1.5 93 63.4 1 100 100 0
eter values so as to illustrate the situations when the FM test pro-
vides an incorrect conclusion about the CAPM. The goal is twofold: Panel C: r2f 0:1
we would like to show that the FM test can be potentially mislead- 1.5 99 64.6 93.8 100 100 74.8
ing, and to investigate how severe the size and power problem is, 1.24 93 48.6 95.2 100 100 91
1 87.4 33.4 93.4 100 97.6 78.4
including the parameter values, at which it should be anticipated.
0.6 73.6 16.6 83 100 72.8 23.4
In practice, the conclusion that the CAPM fails can result from 0.3 66.4 7.2 70 100 30.6 2.8
the following three cases: (1) when the GRS test rejects the null 0 63.2 4.8 52 100 9 0.2
that alphas are jointly zero; (2) when the FM test rejects the null 0.3 66.2 7.6 35 100 28 0
that the slope coefcient equals its population value; and (3) when 0.6 74.8 16 21.4 100 71 0
1 88 33.6 7.2 100 98.6 0
the FM test accepts the null that the slope coefcient equals zero. 1.5 97.8 62.4 1 100 100 0
Thus, in what follows, we refer to any of these cases as the CAPM
failure. Panel D: r2f 0:5
Let us rst discuss the case when the CAPM holds exactly, i.e. 1.5 100 59.4 72.8 100 88.6 35.6
the pricing errors are all equal to zero.16 When T = 60, the GRS test 1.24 100 48.6 75.8 100 85.6 38.8
1 100 39.4 75.2 100 79.8 34.8
rejects the (correct) null hypothesis of all zero alphas 3.6% of the
0.6 100 32 68.4 100 69.8 29.4
times. The FM test, on the other hand, rejects the null of the slope 0.3 100 27.2 61.4 100 64 22.8
being equal to its population value in 19.2% cases, while the accep- 0 100 24.2 48.6 100 61.2 17.4
tance rate for the null of the slope being equal to zero is 50.8%. 0.3 100 25.8 39.2 100 66 11.2
Increasing the sample size improves the situation. In particular, with 0.6 100 30.8 31 100 70.8 6.6
1 100 41.2 18.8 100 77.2 2.2
really large sample sizes (T = 500), the corresponding results for the 1.5 100 60 9.6 100 87.4 0.2
three tests are 1%, 1% and 0%, respectively. Therefore, while the re-
sults are meaningful for large samples, if we use the conventional Panel E: r2f 1
FM test, we are equally likely to accept or reject the true null hypoth- 1.5 100 59 48.4 100 87.2 20.6
esis when typical sample sizes are used. 1.24 100 55.6 49.4 100 84.6 18.2
1 100 54.6 49 100 82.4 17.6
The main results with non-zero pricing errors are presented in
0.6 100 53.4 46.8 100 78.6 15.4
Table 1. The panels of Table 1 assign various values to r2f . Each line 0.3 100 51.8 43.2 100 78.4 15.4
is a separate run of 500 replications for a different value of u. The 0 100 50.6 39.4 100 81.8 15.4
values assigned to the bias (u in Eq. (4)) are given in the rst 0.3 100 51.2 37.6 100 82.2 14.4
0.6 100 53.2 33.8 100 85.6 12.2
1 100 58.4 29.2 100 83.8 10.2
15
In the basic setup we use equally-weighted Market Index. 1.5 100 61.8 21.2 100 85.2 7.2
16
Here we still use 500 replications.
 I. Murtazashvili, N. Vozlyublennaia / Journal of Banking & Finance 36 (2012) 10571066
Fig. 1. Cross-sectional distribution of equally-weighted beta. This gure plots a histogram of equally-weighted betas for 25 book-to-market and size sorted portfolios
estimated on monthly data from 2003 to 2007.
column. Columns 24 represent the case when the time dimension
T is set to 60. The second column contains the percentage of repli-
cations where the GRS test rejects the null hypothesis that 24 port-
folio alphas are jointly zero (i.e. concludes that the CAPM fails) at
5%. Column (3) is the percentage of rejections (at 5%) for the FM
test of the null hypothesis that the coefcient on beta is equal to
the true market risk premium l (i.e. concludes that the CAPM
fails). This column indicates the ability of the FM test to estimate
the risk factor premium correctly. The fourth column gives the
percentage of replications where the FM test accepts the null
hypothesis that the coefcient on beta is zero, thus, concluding
that the CAPM fails. Columns 57 contain the same variables as
columns 24, except that the former columns represent the case
when T = 500.
When both the bias u and f are small (r2f is set close to zero, see
the rst panel) pricing errors are insignicant, i.e. the CAPM
(almost) holds in the sample. In this scenario tests should conclude
that the model fails with a low probability. The GRS test behaves
exactly so: the percentage of the CAPM rejections when u and r2f
are small is not large. For example, when the bias is 0.3 and r2f
is 0.01, the GRS test rejects the null that all alphas are zero in only
5% of the cases. The parameter sensitivity of this test is also as ex-
pected: when the bias becomes large in absolute value the percent-
age of the CAPM rejections increases. For instance, at u of 1.5 and
r2f of 0.01 the rejection ratio grows to 89%. Similarly, for higher lev-
els of r2f the GRS test is more likely to reject the null hypothesis of
all alphas being zero. For example, having the bias parameter of
0.3 and increasing r2f to 0.5 raises the CAPM rejection probability
to 100%. That is, the GRS test is less sensitive to changes in u when
r2f is larger. For Panels D and E (r2f is equal 0.5 and 1, respectively)
the test is not sensitive to the bias at all. This happens because the
effect of the increase in r2f on pricing error is much more pro-
nounced than the effect of changes in u. Overall, we conclude that
the GRS test is able to correctly assess if the CAPM is valid. When
pricing errors become large (while we keep the return volatility
xed) the GRS statistic detects them with a high probability.
The behavior of the GRS test is expected given that u and r2f
directly affect pricing errors (see Eq. (10)). Since the time-series
variation in returns is xed (matrix V), increasing pricing errors
raises the GRS statistic, increasing the probability to reject the
CAPM. As we already discussed, Eq. (4) shows that increasing r2f
unambiguously raises the absolute magnitude of pricing errors,
while the effect of increasing the bias u in absolute value on pric-
ing errors is not as straightforward. For portfolios with b > 1 this
effect is positive, while for portfolios with b < 1 it is negative. The
pricing errors are also weighted by matrix V in the GRS statistic.
1061
Since betas are computed using V, the sensitivity of the GRS test
to u depends on the structure of V. In our case there are slightly
more portfolios with b > 1 as indicated by Fig. 1 (cross-sectional
distribution of betas). Thus, we expect to see a positive effect of
raising the absolute value of u on the GRS statistic.
Now let us turn to the simulation results for the FM test. Since
the GRS test provides the correct conclusions in our set up, we use
it as a reference point when discussing the results of the FM test.
When r2f 0:01 and u = 1.5 the FM test accepts the null hypothe-
sis that c is equal to zero with low probability (less than 1%), sug-
gesting that the risk factor is relevant and the model holds. The
GRS statistic concludes that the CAPM fails in this scenario 88.4%
of the time. At a smaller bias value the FM test accepts the null
hypothesis that c = 0 and concludes that the CAPM fails with high-
er probability. The maximum acceptance ratio (95.2%) is reached
when the bias is negative and in absolute value equals l (1.24).
Pricing errors in this case are large relative to the variation in re-
turns (V) since the GRS test rejects the model in 70.8% of the cases.
Keeping r2f xed, the spread in the null acceptance ratio of the FM
statistic for large and small values of the bias is quite large. For
example, at r2f 0:05 when u = 1.5 the test accepts the null that
c = 0 (i.e. concludes that the model fails) in 1% of the cases, while
at u = 1.24 the acceptance rate is 95%. This spread decreases for
larger values of r2f : at r2f 1 the minimum and maximum ratios
are 21.2% and 49.4%, respectively. Thus, the FM test is more sensi-
tive to changes in u when variation in f is small.
We have shown that the FM test can provide incorrect conclu-
sions about the CAPM. However, as we argue in the previous sec-
tions, it is possible that the FM statistic gives correct predictions
about the model for some parameter values. Our simulation results
conrm this intuition. For example, the difference between the
probability to reject the CAPM based on the GRS and FM tests is
only 0.2% when r2f 0:05 and u = 1.5. The next best scenario
for the FM test (4% difference in the probabilities that the CAPM
fails) is observed at r2f 0:01 and u = 1.5. But such cases are rare.
Moreover, it appears to be almost impossible to anticipate the best/
worst case scenarios in practice. The reason is these scenarios are
jointly determined by parameters r2f ; u; V; l , which are not
observed.
Let us now turn to the null hypothesis of c1 = l in the FM test
as an alternative way to assess the performance of the FM proce-
dure. When this null hypothesis is true, it implies that the CAPM
holds. With this null hypothesis the probabilities of rejecting the
CAPM are different in values from those discussed previously,
but their sensitivity to the changes in parameter values is similar.
If we compare the probability of rejecting the CAPM based on this
1062 I. Murtazashvili, N. Vozlyublennaia / Journal of Banking & Finance 36 (2012) 10571066

Table 2 and does not correct the problems with the FM test. Overall, the FM
The GRS and the FamaMacBeth t-tests with sample-estimated betas. This table test based on the null that c = 0 is less likely to conclude that the
reports simulation results of the GRS test and the FamaMacBeth (FM) t-test for 25
size and book-to-market sorted portfolios. The number of runs is 500, the number of
CAPM fails most of the times in this set up regardless of whether
time periods in each run is 60. Returns are simulated from the joint Normal the CAPM (almost) holds or grossly fails.
distribution with the covariance matrix estimated on monthly data for portfolio Table 2 reproduces the rst two panels and the rst four col-
returns in 20032007. Betas used in the CSRs are estimated on the same sample of umns of Table 1 when betas used in the CSRs are unknown, i.e.
returns. The average equally weighted market portfolio mean is estimated as 1.24,
have to be estimated on the generated sample of returns in each
while each portfolio mean is calibrated with parameters r2f and u. Column (1) is the
bias. Column (2) is the percent of all the replications where H0: a1 =    = aN1 = 0 is run of the simulations. The numbers are very similar to those
rejected by the GRS test. Column (3) is the percent of all the replications where H0: obtained when betas are computed directly from the covariance
c = l is rejected by the FM t-test, while c is the slope coefcient from the regression matrix V (betas are known) as in the basic set up. The main conclu-
of Ri on bi. Column (4) is the percent of all the replications where H0: c = 0 is accepted sions outlined previously fully apply in this case, as well. We con-
by the FM t-test.
clude that the assumption that betas are known does not
u GRS FM signicantly alter the main conclusions of our simulations.
H0: a = 0 H0 : c = l H0: c = 0 Now we consider what happens if we change the covariance
(1) (2) (3) (4) matrix V and mean l. These parameters are now estimated on
Panel A: r2f 0:01 monthly data from a different time interval (19931997). We
1.5 88.4 70.8 69.6 report the results in the rst four columns of Table 3. The GRS
1.24 68.4 62.8 77.8 rejection probabilities are consistently slightly smaller in Table 3
1 39.4 56.4 80.2 than in Table 1. A possible explanation of this result is that the
0.6 8 35.4 72.4
time-series variation in returns is a bit larger in the earlier time
0.3 2.4 16.8 60
0 1.4 5.4 40 period, which makes it harder to detect pricing errors. From
0.3 1.6 1.4 16.4 Fig. 2 we observe that beta is more skewed in the case of Table 3
0.6 5.2 5.4 3 compared to Table 1 setting, which results in a less pronounced
1 33.2 13.8 0.2
effect of changes in u on the FM test. We still see though that
1.5 87 20.2 0
the difference in the probability to reject the CAPM based on the
Panel B: r2f 0:05 GRS and FM tests can be quite large. The latter occurs for different
1.5 92.8 71.8 65.2 parameter values in Table 3 and Table 1, however. This shows the
1.24 80.2 65.6 73.4 importance of the structure of the covariance matrix V for the rel-
1 62 57 74.8 ative performance of the two tests, and conrms that it is very hard
0.6 24.2 35.6 65.2
to predict in practice when these probabilities are similar for both
0.3 12 18.2 51.8
0 9.2 6 33.4 tests.
0.3 10.6 2.4 12.8 To highlight the effect of changing the bias up to this point we
0.6 22.2 5.4 2 have used only equally-weighted market portfolio and equally-
1 55.8 14.2 0
weighted betas. Now we turn to the analysis of the robustness of
1.5 92.8 21.2 0
our conclusions when value weighting is incorporated in the sim-
ulations. There are two differences between this scenario and our
basic setup: rst, betas are computed as value-weighted linear
test to that of the GRS test, the smallest difference (0.8%) occurs at combinations of rows in the matrix V, and, second, the market
r2f 0:01 and u = 0.3, and it can be as large as 50%. So even if we portfolio is now a value-weighted average across portfolios. Value
use a different null hypothesis in testing the CAPM (assuming that weights are estimated for each portfolio for December 2007. The
the true value of the risk premium is known) the FM test has still results are presented in the last three columns of Table 3, which
low power and large size as is the case with the more conventional we compare to our basic results in the rst four columns in Table
null hypothesis of c = 0. 1. The difference between the two tables for the GRS statistic is
In sum, as we increase the magnitude of pricing errors but not similar to the difference in the results presented in the rst four
the variances and covariances of returns, the GRS test successfully columns of Table 3 relative to those in Table 1. Unlike the latter
detects pricing errors and correctly rejects the CAPM. The FM test case, though, we can now trace the pure effect of changes in betas
may provide incorrect conclusions in many cases due to the inu- keeping parameters of the joint Normal distribution of the returns
ence of the bias introduced by the cross-sectional correlation xed. We look again at the cross-sectional distribution of value-
between pricing errors and betas. weighted betas (Fig. 3) compared to that of equally-weighted betas
(Fig. 1). In the former case the distribution of betas is more skewed.
5.2. Robustness tests Once again this leads to a less pronounced effect of changing u
observed in the last three columns of Table 3. At the same time,
We now turn to a discussion of several robustness tests of our the difference in conclusions about the CAPM provided by the
results. Thus far, the only two parameters we have changed are GRS and FM tests can be still quite large.
r2f and u. However, our earlier discussion notes that the tests sen- Additionally, we check the performance of the GRS and FM tests
sitivity to the bias and r2f depends on the covariance matrix V and for the scenario where the CAPM holds exactly (all alphas are zero)
the market risk premium l. Since in reality betas need to be esti- when value weights are incorporated into the analysis. The results
mated, incorporating sample-estimated betas is a necessary are quite similar to what is observed in the equally-weighted case.
robustness check. Changing the time dimension T and the cross- When T = 60, the GRS concludes that the CAPM fails in 3.6% of 500
sectional dimension N is also important as it allows one to assess replications. With the null of the slope being equal to its popula-
asymptotic properties of the tests. Further, as we mention previ- tion value the FM test concludes that the CAPM fails 19.2% of the
ously, value weights need to be incorporated into the analysis. times, while the probability to reject the CAPM with the null of
Simulation evidence on the performance of the tests when we vary zero slope is 49.4%. Similarly to the equally weighted case, when
these parameters will be the focus of the discussion that follows. we increase T substantially, the performance of the FM test
Increasing the time dimension to T = 500 (the last three col- improves. In particular, when T = 500, the corresponding gures
umns of Table 1) results in a higher rejection ratio by the GRS test, are 4.2%, 1.8% and 0%, respectively. For typical sample sizes, these
 I. Murtazashvili, N. Vozlyublennaia / Journal of Banking & Finance 36 (2012) 10571066 1063

Table 3
The GRS and the FamaMacBeth t-tests for various magnitudes of cross-sectional regression bias and CAPM pricing errors with an alternative covariance matrix and with value
weights. This table reports simulation results of the GRS test and the FamaMacBeth (FM) t-test for 25 size and book-to-market sorted portfolios. The number of runs is 500, the
number of time periods in each run is 60. In Columns 24 returns are simulated from the joint Normal distribution with the covariance matrix estimated on monthly data for
portfolio returns in 19931997. The average equally weighted market portfolio mean is estimated as 1.121, while each portfolio mean is calibrated with parameters r2f and u.
Column (1) is the bias. Column (2) is the percent of all the replications where H0: a1 =    = aN1 = 0 is rejected by the GRS test. Column (3) is the percent of all the replications
where H0: c = l is rejected by the FM t-test, while c is the slope coefcient from the regression of Ri on bi. Column (4) is the percent of all the replications where H0: c = 0 is
accepted by the FM t test. Columns 57 have the same meaning as Columns 24 except beta and market portfolio are value weighted and the market average portfolio mean is
1.24.

u GRSalt FMalt GRSvw FMvw

H0: a = 0 H0: c = l H0 : c = 0 H0: a = 0 H0: c = l H0: c = 0
(1) (2) (3) (4) (5) (6) (7)

Panel A: r2f 0:01

1.5 65 94 31.6 88.6 95.6 43.4
1.24 42.2 91.2 34.2 71.4 92.6 47
1 23.8 86 34.4 45.6 87.6 45.2
0.6 8.2 72.2 31 15.8 71.2 28.2
0.3 4.2 66.8 20.6 6.2 59 16.8
0 2.6 67 10 3 53 8.8
0.3 4.6 65 5.4 4.2 57 2.8
0.6 9 71 2.2 12.6 70.4 0.6
1 24.4 85.4 1.4 32 86.4 0
1.5 62.4 95.8 0.2 74.6 96.6 0

Panel B: r2f 0:05

1.5 76.4 94 33 94.2 95.2 46.4
1.24 59.2 90.4 37 82.2 91.2 50.4
1 44.4 85 36.6 69.4 85.8 48
0.6 23.4 72 32.2 40.8 67.6 31
0.3 15.8 65.8 22 28.4 54.4 19.2
0 13 63.8 10.2 24 49.6 9.6
0.3 16.4 63.6 5.6 26.6 53.8 3
0.6 21 69.6 3.2 35 67.8 0.8
1 43 85.2 1.4 55.4 83.8 0
1.5 76.4 95.2 0.2 85.2 96.4 0

Panel C: r2f 0:1

1.5 93.8 93 37.6 98.8 92.6 52.4
1.24 86.4 88.6 40.6 95.6 88.8 57.6
1 80.6 81.4 42.4 89 79.8 56.2
0.6 68.2 66.2 36 79.4 62 37.6
0.3 63.8 61.2 26.4 72.8 49 25.2
0 61.4 57.2 13.8 70.4 42.4 12.8
0.3 63.2 60.4 6.6 71.6 46.8 4.8
0.6 67.8 65.2 4.2 74 61 1.6
1 78.8 82 1.6 83.4 78 0.2
1.5 90.6 94.4 0.2 96 94 0

Panel D: r2f 0:5

1.5 100 65.4 73.6 100 51.6 87.4
1.24 100 55.2 74.8 100 44 89.6
1 100 46.8 67.8 100 34.4 88.8
0.6 100 33 69 100 22.6 80
0.3 100 25 59.8 100 14 68.4
0 100 22.4 49.4 100 10.4 57.8
0.3 100 24.2 39.2 100 12.4 46.6
0.6 100 32.6 30.2 100 18.2 38.2
1 100 46.8 21 100 33.4 26.2
1.5 100 62.8 9.8 100 52.6 18.4

Panel E: r2f 1
1.5 100 35.8 87.4 100 23.8 96
1.24 100 27.6 86.6 100 18.6 96
1 100 22.4 86 100 14.6 96.4
0.6 100 15 84.2 100 7.6 92.8
0.3 100 12.4 80.4 100 4.4 88.4
0 100 14.2 75.4 100 4 83
0.3 100 14.4 67.6 100 4.2 76.2
0.6 100 17 60.6 100 6.8 70.4
1 100 22.2 51 100 12.2 59.4
1.5 100 33 36.6 100 21.8 48.2

results complement ndings in Grauer and Janmaat (2009), which Finally, we repeat our simulations for six equally-weighted
show that the CSR is unable to produce a slope estimate close to its portfolios (results are available upon request). In this case we have
population value when the CAPM holds exactly. a different portfolio covariance matrix V, resulting in a different
1064 I. Murtazashvili, N. Vozlyublennaia / Journal of Banking & Finance 36 (2012) 10571066
Fig. 2. Cross-sectional distribution of alternative beta. This gure plots a histogram of equally-weighted betas for 25 book-to-market and size sorted portfolios estimated on
monthly data from 1993 to 1997.
Fig. 3. Cross-sectional distribution of value-weighted beta. This gure plots a histogram of value-weighted betas for 25 book-to-market and size sorted portfolios estimated
on monthly data from 2003 to 2007.
distribution of beta. The cross-section of portfolio betas for six
portfolios is similar to 25 portfolios. Not surprisingly, the differ-
ences between these results and those in Table 1 are very similar
to the difference observed between Tables 3 and 1. In sum,
combining assets into a smaller number of portfolios is likely to
diminish the effect of changing u on the FM statistic.
5.3. Power and size of the CSR-based tests in practice
So far our goal has been to simulate the means of assets returns
to illustrate situations when CSR-based tests lead to an incorrect
conclusion about the CAPM. In this section we demonstrate how
likely these situations are in practice. Specically, we investigate
what happens when we use the data estimated (instead of gener-
ated) means of asset returns in our simulations. We use ve-year
intervals of monthly data for 25 book-to-market and size sorted
portfolios to estimate l and V.17 The results are given in Table 4.
Column (1) of Table 4 reports the time interval used to obtain the
covariance matrix and the vector of means. Column (2) contains the
number of months available for estimation of the matrix V and the
17
Since some portfolios contain missing data, less than 60 observations are
sometimes used in parameter estimation. However, in simulations we always create
returns of each portfolio for 60 time periods.
means. Column (3) reports the estimated average return of the
equally-weighted market portfolio. In column (4) we present esti-
mates of the cross-sectional bias in each period. Column (5) is the
percent of all the replications where the null of all alphas equal zero
is rejected by the GRS test. Column (6) contains the percent of all the
replications resulting in rejection of the null hypothesis c = l by the
FM test. The percent of all replications where H0: c = 0 is accepted by
the FM test is presented in the seventh column. Column (8) contains
the estimated variance of the error from the regression of ai on bi.
The ninth column is the estimated variance of the difference be-
tween Ri and li averaged across the replications, while the last col-
umn presents its estimated standard deviation. The last two
columns give an assessment of the problems introduced into the
CSR test when Ri is used in place of the true asset mean, assuming
that betas are known and the pricing errors are zero.
The probabilities to reject the CAPM in different time intervals
are now harder to compare since we cannot hold any of the param-
eters xed. In most of the cases, though, these probabilities are
quite different between the GRS and FM tests. The lowest differ-
ence (for the FM null hypothesis c = 0) is observed in 19982002
period (0.8%), and it can be as large as 83.4% (in 19631967). Note
that the bias changes substantially from period to period and can
be either positive or negative (more often negative). This empirical
result is consistent with the negative cross-sectional correlation
 I. Murtazashvili, N. Vozlyublennaia / Journal of Banking & Finance 36 (2012) 10571066 1065

Table 4 main conclusions survive these transformations. Finally, we aban-

The GRS and the FamaMacBeth t-tests when all the joint distribution parameters are don the control of the model pricing errors and bias and estimate
estimated on data. This table reports simulation results of the GRS test and the Fama
MacBeth (FM) t-test for 25 size and book-to-market sorted portfolios. The number of
the means together with the covariance matrix of the joint distri-
runs is 500, the number of time periods in each run is 60. Returns are simulated from bution of returns on data. This is done in order to investigate
the joint Normal distribution with vector of means and covariance matrix estimated scenarios, which are likely to happen in practice. We report that
on monthly data for portfolio returns in various periods. Column (1) is the time period most of the times in practice the bias is substantial and the FM test
used to obtain the covariance matrix and the vector of means. Column (2) is the
is a subject to the criticism we have presented so far.
number of months available for estimation in each time interval. Column (3) is the
estimated average return of the equally-weighted market portfolio. Column (4) is the Overall, our evidence suggests that the CSR-based test may not
estimated cross-sectional bias in each period. Column (5) is the percent of all the be a very good approach to testing (time-series) linear factor mod-
replications when the CAPM is rejected by the GRS test. Column (6) is the percent of els. There are several potential solutions to the problem. A recent
all the replications resulted in rejections by the FamaMacBeth t-test if the null study by Petersen (2009) advocates the use of panel methods with
hypothesis is c = l, where c is the coefcient from the regression of Ri on bi. Column
(7) is the percent of all the replications resulted in acceptance by the Fama-McBeth t-
clustering to avoid problems with standard errors. Another
test of H0:c = 0. Column (8) is the estimated variance of the error from the regression approach is using generalized least squares (GLS) regressions as
of ai on bi. suggested, for example, in Shanken (1985), Roll (1985) and Kandel
T l u
and Stambaugh (1995). Tests based on the GLS regressions make
Period GRS FM r2f

use of the time-series variation in returns by implementing returns
H0: a = 0 H0 : c = l H0: c = 0
covariance matrix as a weighting matrix.
(1) (2) (3) (4) (5) (6) (7) (8)
20032007 60 1.2 0.8 95.8 24.6 91 0.0
19982002 57 1.0 1.1 94.2 13.8 95 0.2
Acknowledgments
19931997 60 1.1 2.3 100 88.2 65.2 0.1
19881992 59 1.2 1.4 100 31.6 95.4 0.0 We thank the Editor and an anonymous referee for valuable
19831987 59 1.1 2.7 100 88.6 55.6 0.1 comments, which have been of great help in improving the quality
19781982 58 1.7 0.5 69.2 8 80.4 0.3
of the paper. We also thank Stuart Gillan, Drew Winters, Jean-
19731977 58 0.7 0.9 64.8 10.4 80.4 0.3
19681972 56 0.8 0.6 79.6 8 94 0.0 Francois Richard, and seminar participants at the Area of Finance,
19631967 57 2.0 0.3 93.8 7.4 10.4 0.1 Texas Tech University.
19581962 59 1.3 0.7 83.6 13.4 90.6 0.1
19531957 60 0.7 1.2 99.4 41.2 89 0.1
19481952 59 1.4 0.8 85.6 12.2 90.8 0.1 Appendix A
19431947 59 2.4 0.0 58.6 4.6 31.8 0.1
19381942 53 3.6 1.3 70 11.2 71 0.1 We generalize the argument in Section 2 by allowing an arbi-
19331937 49 6.7 1.3 86 7.4 41 0.5 trary number of factors (say, K). Suppose the N  1 vector Rt of ex-
19281932 44 2.9 1.6 100 9.4 94.8 13.2
cess returns is generated by the following equation:
Rt a b1 f1t B2 F2t ut ; 11
between estimated pricing errors and betas observed in Black et al. where a is the N  1 vector of pricing errors for N assets, b1 is the
(1972). N  1 vector of sensitivities of securities to factor 1 (f1), B2 is the
N  (K  1) matrix of the sensitivities of the assets to the remaining
K  1 factors dened by the (K  1)  1 vector F2, and ut is the N  1
6. Conclusions
vector of random errors. Then, the CSR of Rt on betas for each factor
is given by:
We investigate the power and size of the FamaMacBeth (CSR-
based) test at different magnitudes of CAPM pricing errors when Rt c0t b1 c1t B2 c2t et : 12
these errors are correlated with betas. We specically trace the
Dene the N  N matrices M and Mf as M = I  i(i0 i)1i0 and
probability that the test rejects the CAPM at certain parameter val- 1
Mf I  MB2 B02 MB2 B02 M, where i is the N  1 vector of ones,
ues. We are mainly interested in two parameters, the correlation of
I is the N  N identity matrix. Matrix M is the residual matrix in
pricing errors and betas and the variance of the part of pricing error
the CSR of returns on the intercept only. Matrix Mf is the residual
that is unrelated to beta. Both of these parameters determine the
matrix in the regression of MRt on Mb1 and MB2. By the properties
magnitude of the CAPM pricing errors and the CSR bias. We show
of residual matrices we have: MfMB2 = 0, MM = M, M = M0 ,
that, depending on the specic parameter values, the FM test may
MfMf = Mf, and M0f Mf . Then, the CSR coefcient on beta of the
either reject the CAPM when it almost holds (i.e. make Type I er-
rst factor is given by the following expression:
ror), or accept the model when it is false (i.e. make Type II error).
Moreover, it is hard to know in practice when the test will lead
 1
c^1t b01 MMf Mb1 0
b1 MMf MRt
to the correct conclusion. The test that the slope is equal to zero  0 1 0
tends to be more problematic than the test that the slope is equal b1 MMf Mb1 b1 MMf Ma b1 f 1t B2 F2t ut
to the excess return on the market. But the latter is harder to  0 1 0
b1 MMf Mb1 b1 MMf Ma
implement in practice since the market expected excess return  0 1 0
has to be estimated. To evaluate the degree of the problems with b1 MMf Mb1 b1 MMf Mb1 f 1t
the FM test we compare its performance to that of the GRS test,  0 1 0
b1 MMf Mb1 b1 MMf MB2 F2t
which, as we show, usually provides the correct predictions in
 0 1 0
our set up. Even though in some cases the difference in the esti- b1 MMf Mb1 b1 MMf Mut
mated probability that each test rejects the CAPM can be as small  0 1 0
as 0.2%, it is usually substantial and can be over 90%. b1 MMf Mb1 b1 MMf Ma f1t
We perform several robustness checks of our main results. We  0 1 0
b1 MMf Mb1 b1 MMf Mut : 13
consider a different time dimension, estimate the market risk pre-
mium and covariance matrix of returns on a different interval, use Interpretation of the three parts in the above equation is the same
equally weighted and value weighted market index, and repeat as in the case with a single risk factor: the rst term is zero if the
simulations for six in addition to 25 portfolio returns. All of the CSR is consistent (otherwise it is the bias), the last term approaches
1066 I. Murtazashvili, N. Vozlyublennaia / Journal of Banking & Finance 36 (2012) 10571066
zero for large N. Ignoring these two terms the CSR slope coefcient
on the rst risk factor beta is the factor itself at time t.
References
Balduzzi, P., Robotti, C., 2008. Mimicking portfolios, economic risk premia, and tests
of multi-beta models. Journal of Business and Economic Statistics 26, 354368.
Black, F., Jensen, M.C., Scholes, M., 1972. The capital asset pricing model: some
empirical ndings. In: Jensen, M.C. (Ed.), Studies in the Theory of Capital
Markets. Praeger, New York.
Cochrane, J., 2001. Asset Pricing. Princeton University Press, Princeton, NJ.
Connolly, R.A., Rendleman, R.J., 2007. A simulation-based assessment of cross-
sectional CAPM testing methodology. Working paper, University of North
Carolina.
Fama, E.F., French, K.R., 1998. Taxes, nancing decisions, and rm value. Journal of
Finance 53, 819843.
Fama, E.F., MacBeth, J.D., 1973. Risk, return and equilibrium: empirical tests. Journal
of Political Economy 81, 607636.
Gibbons, M.R., Ross, S.A., Shanken, J., 1989. A test of the efciency of a given
portfolio. Econometrica 57, 11211152.
Grauer, R.R., 1999. On the cross-sectional relation between expected returns, betas,
and size. Journal of Finance 54, 773789.
Grauer, R.R., Janmaat, J.A., 2009. On the power of cross-sectional and multivariate
tests of the CAPM. Journal of Banking and Finance 33, 775787.
Grinstein, Y., Michaely, R., 2005. Institutional holdings and payout policy. Journal of
Finance 60, 13891426.
Hou, K., Kimmel, R.L., 2006. On estimation of risk premia in linear factor models.
Working paper, Ohio State University.
Jagannathan, R., Wang, Z., 1998. An asymptotic theory for estimating beta-pricing
models using cross-sectional regression. Journal of Finance 53, 12851309.
Kan, R., Zhang, C., 1999. Two-pass tests of asset pricing models with useless factors.
Journal of Finance 54, 203235.
Kandel, S., Stambaugh, R.F., 1995. Portfolio inefciency and the cross-section of
expected returns. Journal of Finance 50, 157184.
Kim, D., 1995. The errors in the variables problem in the cross-section of expected
stock returns. Journal of Finance 50, 16051634.
Petersen, M.A., 2009. Estimating standard errors in nance panel data sets:
comparing approaches. Review of Financial Studies 22, 435480.
Roll, R., 1985. A note on the geometry of shankens t2 test for mean/variance
efciency. Journal of Financial Economics 14, 349357.
Roll, R., Ross, S.A., 1994. On the cross-sectional relation between expected returns
and betas. Journal of Finance 49, 101121.
Shanken, J., 1985. Multivariate tests of the zero-beta CAPM. Journal of Financial
Economics 14, 327348.
Shanken, J., 1992. On the estimation of beta-pricing models. Review of Financial
Studies 5, 133.
Shanken, J., Zhou, G., 2007. Estimating and testing beta pricing models: alternative
methods and their performance in simulations. Journal of Financial Economics
84, 4086.