Testing the CAPM: A Simple Alternative to Fama and MacBeth (1973)

Paper Number: 06/04 Cherif Guermat, George Bulkley*, Mark C. Freeman* and Richard D.F. Harris* Department of Economics and *Xfi Centre for Finance and Investment University of Exeter

Author for Correspondence Xfi Centre for Finance and Investment University of Exeter Exeter EX4 4ST England Tel: +44-(0) 1392-263155 Fax: +44-(0) 1392-262525 Email: Mark.C.Freeman@exeter.ac.uk C.Guermat@exeter.ac.uk R.D.F. Harris@exeter.ac.uk I.G. Bulkley@exeter.ac.uk

Testing the CAPM: A Simple Alternative to Fama and MacBeth (1973)

Abstract

Most studies that use the method of Fama and MacBeth (1973) to test the Capital Asset Pricing Model (CAPM) are unable to reject the null hypothesis that beta and expected returns are uncorrelated. This paper introduces a simple new test which has the CAPM as its null hypothesis. We show theoretically, by simulation and by using market data that our proposed test has greater power than that of Fama and MacBeth. The new test helps to establish whether the ndings of previous studies result from the low power of the Fama and MacBeth test or from a failure of the CAPM. JEL classication: G10; G12; C12; C15 Keywords: Capital Asset Pricing, Fama and MacBeth Test.

1. Introduction
Empirical tests of the Capital Asset Pricing Model (CAPM) have been unable to nd a statistically signicant correlation between stock returns and beta (see, for example, Reinganum, 1982; Lakonishok and Shapiro, 1986; Ritter and Chopra, 1989; Fama and French, 1992). These tests typically employ the method of Fama and MacBeth (1973, hereafter FM), which involves estimating a series of monthly cross-section regressions of individual stock returns on beta, and then testing whether the average slope coecient 2

in these regressions is statistically dierent from zero using the time series variation of the estimated slope coecient in order to calculate the standard error of the average slope coecient. Typically these empirical studies do not reject the null hypothesis of the FM test that beta risk is not priced. A question raised by Chan and Lakonishok (1993) is whether the null hypothesis is true or whether the tests just lack the power to reject it in nite samples. They show that,

for realistic levels of market return volatility, the FM test is likely to have low power in samples of the size typically employed in practice. The test cannot reject the null that beta is not priced but it also cannot reject the null of the CAPM assuming any plausible value for the expected return on the market. A researcher who has strong prior beliefs in the CAPM would not be compelled to infer from the point estimate and associated standard error that the CAPM is false. The low power of the FM test arises from the fact that, under both the null and alternate hypotheses, a component of the slope coecient in each monthly cross-section regression is the realized excess market return . This is very volatile, which yields a highly noisy estimated series of monthly slope coecients. It is this noise, which is common to both null and alternative hypotheses, that is responsible for the low power of the FM test. In this paper, we present a simple test in the spirit of Fama and MacBeth (1973) that addresses this problem of low power. Our modied FM test (hereafter Modied FM) involves subtracting the realized excess market return each month from the estimated FM slope coecient. The variance of the test statistic is then signicantly reduced and this results in a sub3

stantial increase in power. This is demonstrated analytically, by simulation and by using real market data. A natural consequence of subtracting the observed excess market return from the estimated FM slope coecient is that the CAPM becomes the null hypothesis of the Modied FM test. This has a major advantage. Hav-

ing the null as the hypothesis that beta is unpriced means that rejecting the null using the FM test is sucient to establish that beta helps explain cross-sectional dierences in expected return. It is, though, not directly

informative about whether the price of beta risk is equal to the equity premium. In contrast, by having the CAPM as its null, nding a Modied FM test statistic that is signicantly dierent from zero is sucient to reject the model. The Modied FM test is therefore a more specic test of the CAPM than FM. There are other recent alternative methods to FM for testing the CAPM, such as Hansens (1982) generalized method of moments (GMM) and the semi-parametric method of Hodgson et al. (2002). GMM based models are theoretically superior to FM as they relax both the normality and the conditional homoscedasticity assumptions (Jagannathan and Wang, 2002). However, GMM based methods do not generally lead to fully ecient estimates (Vorkink, 2003). In addition, Harvey and Zhou (1993) nd little dierence between OLS and GMM based tests, while Ferson and Foerster (1994) provide evidence suggesting that GMM methods lead to asset pricing tests with aberrant properties. The semi-parametric method of Hodgson et al. (2002) seems promising, but the evidence is scant and is based only on a small-scale simulation study (Vorkink, 2003). 4

Thus, although these alternative methods may have more attractive theoretical properties, there is still a lack of empirical evidence in their favor. From a practical point of view, both methods suer from the fact that they are dicult to implement, and that no standard software is available for carrying out estimation and testing using these methods. In contrast, both the FM method and our modication to it combine simplicity with robustness to cross-sectional correlation. They are also easily implemented using standard statistical and econometric software, which makes them potentially attractive methods for practitioners. The simplicity of the FM method-

ology has resulted in its continued popularity. Among the recent studies that have employed the FM methodology are Coval and Moskowitz (2001), Lettau and Ludvingson (2001), Gomes, Kogan and Zhang (2003), Menzly, Santos and Veronesi (2004), and Gompers and Metrick (2001). Variants of the FM method are also used by Gompers, Ishii and Metrick (2003) and Baker, Stein and Wurgler (2003). The outline of the paper is as follows. In the following section, we present the FM test in detail and discuss its small sample properties. In Section 3, we introduce the Modied FM test and compare it with the FM test. Section 4 reports the results of simulation experiments to ascertain the size and power of both the FM test and the Modied FM test. In section 5,

we run the FM and Modied FM tests on US stock market data. We test the CAPM using the FM and Modied FM tests over several subperiods of US market data since 1950. These conrm that the Modied FM test statistic has lower standard error than the FM test statistic. Even with

this increased power, though, it is in many cases not possible to reject the 5

CAPM under the Modied FM test for beta ranked portfolios. Section 6 oers some concluding remarks.

2. The Fama-MacBeth Test

Suppose that there are N securities, with the return to asset i {1, ..., N } between times t 1 and t being denoted by rit . The expected excess return to any asset is given by

E[Rit ] = i + i

(1)

where Rit = rit rf,t1 is the excess return between period t 1 and period t for security i, rf,t1 is the one-period risk free rate at time t 1. i = Cov(Rit , Rmt )/V ar(Rmt ) is the CAPM beta of security i which is assumed to be constant across time and Rmt is the excess return on the market portfolio. is the price of beta risk. Under the CAPM, = E[Rmt ] while, if beta is not priced, = 0. i incorporates the elements of the expected return that are not captured by beta. This may include size eects, book-to-market It is assumed that

eects or additional Arbitrage Pricing Theory eects.

i does not vary across time. Again, if the CAPM is true, i = 0 for all i. Now consider the realized excess return to each asset minus its expectation; it = Rit E[Rit ]. This can, without loss of generality, be linearly projected against mt , the realized excess return to the market portfolio minus its expectation: it = proj(it |mt ) + vit (2)

where the projection term is dened by proj(it |mt ) = E[it mt ] mt = i mt E[2 ] mt (3)

i , dened above, is the true, or population, CAPM beta. For ease of exposition, it will be assumed that this is always estimated without error. It is easily established that E[vit ] = E[vit mt ] = 0.1 We will further impose the restriction that E[vit vj ] = 0 for all i, j including i = j and 6= t. This, essentially, is restricting asset excess returns to display zero autocorrelation. There is no requirement here that the disturbance terms are cross-sectionally independent as they may, for example, within an Arbitrage Pricing Theory context, include co-movement with other macroeconomic factors. This

general framework emphasizes that betas are informative about the ex-post relationship between individual asset returns and the realized return to the market portfolio. This, though, is not the central element of the CAPM, which makes predictions about the ex-ante, pricing, eects of beta captured by = E[Rmt ] and i = 0. Equation 2 can be re-expressed as: Rit = E[Rit ] + i (Rmt E[Rmt ]) + vit (4)

Consider the following cross-section regression between excess returns and beta, which is commonly used in empirical studies of the CAPM:

Rit = at + t i + it
1

(5)

To establish these results (i) take expectations of equation 2 and (ii) multiply both

sides of this equation by mt and then take expectations. Here we are invoking a standard asset pricing technique that is often used within a stochastic discount factor setting. See, for example, Cochrane (2001, p.18).

The OLS estimate of t is given by Covi (Rit , i ) V ari ( i ) (6) Covi (E[Rit ], i ) + Rmt E[Rmt ] + t = V ari ( i ) P P 1 P 2 where t = S i ( i )vit , S = i ( i ) and = (1/N ) i i. b t =

The notations Covi and V ari denote the sample covariance and variance, respectively, evaluated over the cross-section dimension. By substituting in for equation 1, it is clear that: b t = + + Rmt E[Rmt ] + t and = (1/N ) P
i i .

(7) Empirical tests

1 where = S

of the CAPM can therefore be formulated as tests of hypotheses about E[t ] in regression (5). In particular, most tests of the CAPM involve testing the null hypothesis that E[t ] = 0, which is consistent with = 0, against the alternative that E[t ] 6= 0.2 If the CAPM holds, then E[t ] = E[Rmt ] and the null hypothesis (E[t ] = 0) should be rejected. The slope coecient t can be estimated straightforwardly by the usual OLS estimator, t , dened above. However, the hypothesis that E[t ] = 0 cannot be tested using a conventional OLS t-statistic because the error term is cross-sectionally correlated under the null hypothesis. Consequently, the usual OLS estimate of the standard error of t will be both biased and inconsistent.3 Indeed,
2

i ( i )(i )

Notice that E(t ) =

also usually assumed that = 0. 3 Both the pooled OLS regression and the Black, Jensen and Scholes (1972) pure cross section regression suer from this shortcoming. See Cochrane (2001) for a discussion.

1 S

i ( i

)E[vit ] = 0. In Fama-MacBeth type tests it is

Cochrane (2001) reports that the errors are so highly cross-sectionally correlated that standard errors can often be underestimated by a factor of ten or more. In a seminal paper, Fama and MacBeth (1973) propose a solution to this problem that exploits the fact that, while the estimated standard error in the regression will be biased, the estimated slope coecient will be unbiased. Fama and MacBeth propose repeatedly estimating the cross section regression equation 5. The point estimate is the time-series mean of the

estimated slope coecient in each of the cross-section regressions:

T 1 X F M = t T t=1

(8)

Under the null hypothesis that E[t ] = 0, E[F M ] = 0, while under the b alternative hypothesis that E[t ] = E[Rmt ], E[F M ] = E[Rmt ]. In order to

test the null hypothesis that E[t ] = 0, Fama and MacBeth propose the test statistic F M SE(F M )

tF M =

(9)

where SE(F M ) = SD(t )/ T 1 and SD(t ) is the sample standard deviation of the T cross-section regressions estimates t . Under the null hypothesis that E[t ] = 0, the FM test statistic has a t-distribution with T 1 degrees of freedom. The FM approach has been used by many empirical studies, including Reinganum (1982), Lakonishok and Shapiro (1986), Ritter and Chopra (1989), Fama and French (1992). These studies have invariably

found that the null hypothesis that E[t ] = 0 cannot be rejected.4 Since the null hypothesis is that expected returns and beta are uncorrelated, the ability of the FM test to reject non-pricing depends upon the power of the test to detect the correlation between beta and expected re turns. This in turn depends upon the standard error of F M , and hence, from equation 8, on the variance of t . In the Appendix, we show that the variance of t is given by 2 2 V ar(F M ) = m + + T T S T where 2 is the variance of Rmt and m
2 = 2S

(10)

XX ( i )( j )Cov(vit , vjt )
i j6=i

(11)

. The power of the FM test therefore depends on the variance of the realized market return, 2 . The higher the variance of 2 , the higher the standard m m deviation of t , the higher the standard error of F M and the lower the power of the FM test. Chan and Lakonishok (1993) show that, for realistic levels of market return volatility, the FM test is likely to have low power in data sets of the lengths typically employed in practice, and is therefore unlikely to reject the null hypothesis that the average slope coecient between returns and beta is zero, even if the CAPM is true. We provide more evidence on the small sample properties of the FM test in Section 4. Note that since the OLS estimator t is unbiased, from equation 7:
4

Fama and MacBeth (1973) is one of the very few studies that found support for the

CAPM.

10

 E[t ] = E[t ] = +

(12)

The null hypothesis in the FM test, therefore, is whether + = 0, whereas the alternative is that + 6= 0. Thus, the FM test does not

specically test the CAPM model which makes three specic predictions; = E[Rmt ], = 0 and that there are no sources of expected return that are orthogonal to beta. captures the eects of sources of risk that aect expected returns and are correlated with beta. example, size eects. This might include, for

Usually the rejection of the Fama-MacBeth null is

seen to support the view that beta risk is priced. Again, though, this need not be the case if 6= 0. The proposed Modied FM test focuses specically on testing the CAPM hypothesis.

3. The Modied Fama-MacBeth Test

The low power of the FM test comes from the fact that the slope coecient in each monthly regression contains the realized excess market return. The high volatility of the realized market return translates into a high volatility of the estimated monthly slope coecient, and consequently into a high standard error of the average estimated slope coecient. In this section, we propose a modication of the FM test that leads to a substantial increase in power to discriminate between the CAPM and non-CAPM hypotheses. To motivate the new test, note that from equation 7, the slope coecient in the FM test has a common component, Rmt , under any hypothesis on the relationship between expected returns and beta (i.e. for any value of ). Our proposal, therefore, is to modify the FM test by rst subtracting 11

 the common component, Rmt , from the estimated slope coecient, t , each month. If the CAPM holds, = E[Rmt ] and hence

t = t Rmt = + E[Rmt ] + t

(13)

Now consider the null hypothesis that the CAPM is true; = E[Rmt ] and = 0. In this case E[bt ] = 0. Rejection of this null is sucient to

reject the CAPM. It will be rejected either because 6= E[Rmt ] or because 6= 0. The Modied FM test is given by MF M SE(MF M )

tMF M = where MF M =
1 T

(14)

mates. Under the null hypothesis that the CAPM holds, the Modied FM test statistic has a t-distribution with T 1 degrees of freedom. By subtracting the realized market return each month, the adjusted slope coecient estimate has lower variance but the same signal, and hence the Modied FM statistic should have higher power to discriminate between the null and al-

sample standard deviation of t over the T cross-section regressions estib

t t,

SE(MF M ) = SD(bt )/ T 1 and SD(bt ) is the

ternative hypotheses. In the Appendix, we show that the variance of the modied statistic, MF M , is equal to 2 + T S T

V ar(MF M ) =

(15)

Thus the variance of MF M is lower than the variance of F M by 2 /T. m

12

Equivalently, we can note that under their respective nulls: 2 b SE 2 (F M ) SE 2 (bMF M ) = m T (16)

In the next section we evaluate the power of the modied FM test to distinguish between CAPM and the alternative hypothesis that returns and beta are uncorrelated using simulation experiments.

4. Simulation Experiments
In this section, we evaluate the small sample properties of both the FM test and the Modied FM test using simulated data. In particular, we generate data under two distinct hypotheses. Under the rst hypothesis, the CAPM holds, while under the second hypothesis, expected returns and beta are uncorrelated. The two models used to generate the simulated data are calibrated using realized monthly returns on 1000 stocks randomly drawn from stocks in the CRSP database that had as least 24 observations over the period January 1968 to December 2000. For each randomly drawn stock i, we use the available time series data from January 1968 to December 2000 to estimate i as the slope of the time series regression of the monthly excess return of each stock on the stock market excess return. The variance of the residuals from this regression 2 i is saved. The excess market return is the monthly CRSP market return minus the US Treasury bill rate (IMF series USI60C). For the rst model, under which the CAPM holds, returns, Rit , are generated as follows. At each date t, excess market returns, Rmt , are drawn from a normal distribution with mean E(Rmt ) and variance 2 . We use m 13

E(Rmt ) = 0.007 and m = 0.055. These values closely match the sample moments of the CRSP data and are similar to those used in Jagannathan and Wang (2002). In order to examine the impact of the volatility of the market return on the small sample properties of the two tests, we also use half the standard deviation ( m = 0.0275). Four time-series sample sizes, T , are considered (60, 120, 240, and 360 months). These time horizons are commonly used in testing the CAPM (see, for example, Fama and French, 1992, and Jagannathan and Wang, 1996). We also consider some cases with a large sample size (T = 1000). Individual excess returns under the null hypothesis of the CAPM are generated by

R1,it

i Rmt + vit

vit N (0, 2 ) i

(17)

where i is randomly drawn, with replacement, from the vector of 1000 estimates of i , and it is randomly drawn from a normal distribution with variance 2 . i For the second model, where beta risk is not priced, individual excess returns are generated by

R2,it

E(Rmt ) + i (Rmt E(Rmt )) + vit

vit N (0, 2 ) i

(18)

The simulation exercise is based on 1000 replications. In each replication, equations 17 and 18 are used to generate individual stock return data. In each replication, and for each of the return-generating models, j = 1, 2, we estimate a series of cross-section regressions Rj,it = j,t + j,t i + ej,it , 14

 t = 1, , T , to yield two series of estimated slope coecients, 1,t , and 2,t , t = 1, , T . For each of the two models, j = 1, 2, the FM statistic is the t-statistic of the sample mean of j,t , given by equation 9, while the Modied FM test the t-statistic of the sample mean of j,t = j,t Rmt , given by equation 14. The FM statistic is then used to test the null hypothesis that expected returns and beta are uncorrelated against the alternative hypothesis that beta is priced, and the Modied FM test is used to test the null hypothesis that the CAPM holds against the alternative hypothesis that 6= E[Rmt ]. In order to compute the size of the FM and Modied FM tests, we calculate the proportion of times each test rejects its respective null hypothesis, when the respective null hypothesis is true. To compute the power of the two tests, we calculate the proportions of times each test rejects its respective null hypothesis, when the respective alternative hypothesis is true. levels. The simulation results for the FM and Modied FM tests are reported in Table 1. For all three signicance levels, the empirical size of both tests under their respective null hypotheses is close to the nominal signicance level. However, the Modied FM test clearly has greater power to discriminate between the two hypotheses. Even at the smallest sample size, the power of the Modied FM test is very close to unity regardless of the volatility of the market return. For the FM test, however, the power is around 20 percent for the smallest sample size when m = 0.055. Even when the variance of the market return is halved, the power is still low, at most 56 percent at the 10% signicance level. To achieve reasonable power, the FM test requires 15 The tests are conducted at the 5% and 10% two-sided signicance

at least 1000 months of data, and even then, the power is still marginally lower than that of the Modied FM test. [Insert Table 1 around here] Some interesting properties of the two tests are shown in Table 2, which reports the mean, standard deviation, and skewness and excess kurtosis coecients of the simulated FM and Modied FM statistics. The two

tests show little dierence under their respective null hypotheses. But the dierence is striking under their respective alternatives. The means of the two statistics have the expected opposite sign, but the dierence in their variance is substantial. Owing to its reduced variance, the Modied FM statistic is around four and a half times greater at all sample sizes. The distribution of the Modied FM statistic under the alternative is to the left of zero as suggested by its 5th and 95th percentiles. The FM statistic is far closer to its value under the null hypothesis, with the 5th percentile becoming negative at lower sample sizes. [Insert Table 2 around here]

4.1. Robustness Check

In this subsection, in order to establish the robustness of our simulation experiments, we consider how the FM and Modied FM tests perform against some alternative data generating processes for returns. As an alternative to the CAPM, Jagannathan and Wang (2002) suggest a model of the form

16

Rit

i + i Rmt + vit

(19)

where i = E(Rit ) i E(Rmt ). In relation to our general specication, this is the case where i + i is unconstrained. This model allows for other rm-specic determinants of expected returns, such as market capitalization and the ratio of book to market value of equity. In the simulation, i is calibrated using the 1000 randomly drawn stocks from the CRSP database, and is calculated as

i = Ri i Rm

(20)

Kan and Zhou (1999) suggest an alternative model that adds noise to the market return. In particular, one of their suggestions is to use

where ft = (Rmt

with nite variance 2 , and which is uncorrelated with vit . Since, E(ft ) = n .p E(Rmt ) 1 + 2 , this is consistent with the CAPM. In the simulation we n use equation 21 to generate the data, using nt N (0, 0.01). Table 3 presents the rejection rates when the data are generated by the Jagannathan and Wang (2002) and the Kan and Zhou (1999) models. For a well specied test, the CAPM should be accepted for the Kan and Zhou model and rejected for the Jagannathan and Wang model. Therefore the FM (Modied FM) test should reject (fail to reject) the null for the Kan and

= i ft + vit vit N (0, 2 ) (21) i .p + nt ) 1 + 2 , nt is a zero mean measurement error n Rit

17

Zhou process. For the Jagannathan and Wang process the FM (Modied FM) test should fail to reject (reject) the null. [Insert Table 3 around here] Panels A and B of the table show that the noisy CAPM of Kan and Zhou is not identied by the FM test. The Modied FM rejects it with the correct size for both levels of market volatility and both signicance levels. Panels C and D of the table show the rejection rate of the two tests when the data are generated by the Jagannathan and Wang noisy Non-CAPM model. While the additional noise does aect the Modied FM test for very small sample sizes, this eect virtually disappears once T = 120. On the other hand, the FM test yields a surprising result. Contrary to expectation, the rejection rate increases with the sample size. Typically, rejection rates of the FM test should remain close to the nominal sizes of 5% and 10%. Indeed, as can be seen from Table 1, the rejection rates for the Non-CAPM data generated by equation 18 are all close to their respective nominal sizes, irrespective of the sample size. What is dierent in the Jagannathan and Wang model is that the Non-CAPM model contains additional noise. This appears to distort the size of the FM test, especially for large values of T . Thus, noise not only seems to worsen the power of the FM test when the null hypothesis is false, but also seems to distort the size of the FM test when the null is true. This suggests that in the presence of additional noise, the FM test may not be able to detect the presence (or lack) of correlation between beta and average returns. Thus, the FM test can potentially fail completely under certain alternative models. In contrast, the Modied FM 18

test performs reasonably well in both cases examined here.

5. Testing the CAPM

In this section, we test the CAPM on US data using the FM and Modied FM tests. We randomly selected 9,000 stocks from the CRSP dataset of 22,716 companies. Stocks with less than 60 consecutive monthly observations throughout the period January 1968 to December 2000 were removed from the sample. This left slightly more than ve thousand stocks available, of which the rst ve thousand were selected for the test. b In the rst stage, the estimated beta of each stock, i , i = 1, ..., 5000,

was calculated. Following standard procedures, these were calculated using a time series regression over all the available observations for each stock

Rit = i + i Rmt + eit

(22)

On the basis of these estimated individual stock betas, 100 beta-ranked portfolios were formed with 50 stocks in each. Again, following standard

Fama-MacBeth procedure, the beta of each portfolio was re-estimated using the 60 months of data prior to the test period in order to remove potential measurement error bias. b This provided estimates of portfolio betas p ,

p = 1, ..., 100. Then t was estimated from the cross section regression

Rpt = at + t p + vpt

(23)

The FM and Modied FM tests are then simply t-tests on the sample mean of the time series t and (t Rmt ), respectively. The results, shown 19

in Table 4, contrast the conclusions of the two tests for a selection of starting dates and sample sizes, T . [Insert Table 4 around here] As expected, the Modied FM test statistic has a substantially lower standard error than the FM test, potentially giving it much greater power. According to equation 16: h i b b 2 = T SE 2 (F M ) SE 2 (MF M ) m (24)

Using this equation to estimate 2 from the standard errors in Table 4, m the average estimated annualized standard deviation of the market is 14.6% with a minimum and maximum estimate of 11.6% and 16.9% respectively, which is broadly consistent with observed returns. Despite the increase in power, the Modied FM test statistic is statistically signicant at the 10% level only twice. From Table 1, it has been established that the null hypothesis that this test statistic is equal to zero is rejected almost 100% of the time if beta is unpriced and if market returns in the test period are normally distributed with a mean of 0.7% per month. These results do, then, give some support to the view that beta can help explain cross-sectional variations in average returns. This is backed by the FM test statistics, which are always positive, of similar value to the estimated equity premium and where, despite the tests low power, the p-value is less than 10% in three out of the nine cases.

20

6. Conclusion
It is known from a large number of studies in empirical asset pricing that it is very dicult to reject the null hypothesis that the correlation between beta and expected returns is zero. This has led some to infer that the

CAPM beta is not priced. However, others have noted that, given the low power of the Fama and MacBeth test and the short test periods employed, the inability to reject the null would be unsurprising even if the CAPM held. In this paper, we note that the key factor that lies behind the low power of the standard FM test is the volatility of realized market returns. The

ex-post excess return to the market is a common component of the test statistic under both the null and alternate hypotheses. We therefore construct an alternate test, the Modied FM, where the realized return to the market in each period is removed from the FM statistic. It is shown theoretically, by simulation and through an empirical study using market data that the Modied FM has greater power than the FM statistic. In principle, therefore, the Modied FM is better able to distinguish between the CAPM and alternative hypotheses. In the nal section of the paper, we have conducted FM and Modied FM tests on various samples of US data. Using beta ranked portfolios, the decreased standard errors of the Modied FM test is clearly demonstrated and is of the expected order of magnitude. It is interesting to see in these results that, when the modied test with substantially enhanced power is applied, in most cases it is not possible to reject the null hypothesis that the CAPM is true.

21

Appendix
As in equation 4, the data generating process is given by:

Rit = E[Rit ] + i (Rmt E[Rmt ]) + vit

(25)

where Rmt = E[Rmt ] + ut , ut iid(0, 2 ), E(vit ) = 0, E(vit vjs ) = 0 for m t 6= s, i, j. We also assume V ar(vit ) = 2 , and E(ut vis ) = 0, i, t, s. v The OLS estimator of t , as in equation 7, is given by

t = + + Rmt E[Rmt ] + t The variance of t is given by

(26)

V ar(t ) = V ar(Rmt ) + V ar(t ) + 2Cov(Rmt , t )

(27)

Consider the covariance term. Since E[t ] = 0 this can be re-expressed 1 P as E[Rmt t ]. Substituting in for t this is equal to E[Rmt S i ( i )vit ]. 1 P Rearranging gives S i ( i )E[Rmt vit ] = 0 from the properties of vit given above. It follows that

V ar(t ) = V ar(Rmt ) + V ar(t )

(28)

As asset excess returns are assumed to be zero autocorrelated, Cov(t , s ) = 0, t 6= s, the variance of F M is given by 1 V ar(F M ) = V ar(t ) T We have V ar(Rmt ) = 2 and, assuming i xed, m 22 (29)

! 1 X V ar(t ) = V ar ( i )vit = S i ! X 1 ( i )vit = 2 V ar S i = = =

2 where = S j6=i

1 XX 2 v + 2 ( i )( j ) Cov(vit , vjt ) S S i 2 v S P + 2 v + ( i )2 i )( j ) Cov(vit , vjt ). Hence (30)

P P
i

j6=i ( i

2 2 V ar(F M ) = m + v + T T S T The estimated variance of F M is dened as V ar(F M ) = where 2 M = F

1 T 1

1 2 T FM

(31)

To compute E[V ar(F M )] rewrite t and F M using (26) t F M = Rmt Rm + t 1 X = ut u + ( i )(vit vi ). S

i 1 T 1

P 2 t (t F M ) .

(32) (33) F M ),

Note that E[ 2 M ] = F

t E[(t

F M )2 ] =

1 T 1

t V ar(t

23

 since E[t F M ] = 0. Hence, 1 X V ar(t F M ) = E (ut u)2 + 2 ( i )2 E (vit vi )2 S i XX 1 ( i )( j ) E [(vit vi )(vjt vj )] + 2 S i i6=j 1 X 1 1 2 m + 1 = 1 ( i )2 2 v 2 T T S i 1 XX 1 + 1 ( i )( j ) Cov(vit , vjt ) 2 T S i i6=j T 1 2 1 2 m + = v + . T S Therefore, E[ 2 M ] F and 2 2 E[V ar(F M )] = m + v + . T T S T (34) 1 T 1 2 1 2 1 2 m + = v + T = 2 + + m T 1 T S S v

Thus, the sample variance of the FM estimator is an unbiased estimator of its true variance. Now turn to the variance of the modied FM statistic, which is given by 1X 1X MF M = t = (t Rmt ) T t T t Using (26), t is given by (35)

t = + E[Rmt ] + t

(36)

Repeating the same steps used above, it follows trivially that the true variance of MF M is given by 24

2 V ar(MF M ) = v + T S T and that the sample variance is unbiased, E[V ar(MF M )] = V ar(MF M ).

25

References
Baker M., Stein J.C. and Wurgler J. (2003) When does the market matter? Stock prices and the investment of equity-dependent rms, Quarterly Journal of Economics, 118, 969-1005. Chan L. and Lakonishok J. (1993) Are the reports of betas death premature?, Journal of Portfolio Management, 19, 5162. Cochrane J.H. (2001), Asset Pricing, Princeton University Press. Coval J.D. and Moskowitz T.J. (2001) The geography of investment: informed trading and asset prices, Journal of Political Economy, 109, 811-841. Fama E. F. and French K. R. (1992) The cross-section of expected stock returns, Journal of Finance, 47, 427465. Fama E. F. and French K. R. (1993) Common Risk Factors in the Returns on Stocks and Bonds, Journal of Financial Economics, 33, 356. Fama E. F. and MacBeth J.D. Risk, Return and Equilibrium: Empirical Tests, Journal of Political Economy, 81, 607636. Hansen L. (1982) Large Sample Properties of Generalized Method of Moments Estimators, Econometrica, 50, 1029-1054. Ferson W. and Foerster S. (1994) Finite Sample Properties of the Generalized Method of Moments in Tests of Conditional Asset Pricing Models, Journal of Financial Economics, 36, 29-55. Gomes J., Kogan L. and Zhang L. (2003) Equilibrium Cross Section of Returns, Journal of Political Economy, 111, 693-732. 26

Gompers P.A., Ishii J. and Metrick A. (2003), Corporate governance and equity prices, Quarterly Journal of Economics, 118, 107-155. Gompers P.A. and Metrick A. (2001), Institutional investors and equity prices, Quarterly Journal of Economics, 116, 229-259. Harvey C. and Zhou G. (1993) International Asset Pricing with Alternative Distributional Specications, Journal of Empirical Finance, 1, 107-131. Hodgson D. J., Linton O. and Vorkink K. (2002), Testing the capital asset pricing model eciently under elliptical symmetry: a semiparametric approach, Journal of Applied Econometrics, 17, 617639. Jagannathan R. and Wang Z. (2002) Empirical evaluation of asset pricing models: a comparison of the SDF and beta methods, Journal of Finance, 57, 23372367. Kan R. and G. Zhou (1999) A Critique of the Stochastic Discount Factor Methodology, Journal of Finance, 54, 1221-1248. Lakonishok J. and Shapiro A.C. (1986) Systematic Risk, Total Risk and Size as Determinants of Stock Market Returns, Journal of Banking and Finance, 10, 115-132. Lettau M. and Ludvingson S. (2001) Resurrecting the (C)CAPM: A CrossSectional Test When Risk Premia Are Time-Varying, Journal of Political Economy, 109, 1238-1287. Menzly L., Santos T. and Veronesi P. (2004) Understanding Predictability, Journal of Political Economy, 112, 1-47.

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Reinganum M.R. (1982) A Direct Test of Rolls Conjecture on the Firm Size Eect, Journal of Finance, 37, 27-35. Ritter J.R. and Chopra N. (1989) Portfolio Rebalancing and the Turn-OfThe-Year Eect, Journal of Finance, 44, 149-166. Vorkink K. (2003), Return Distributions and Improved Tests of Asset Pricing Models, Review of Financial Studies, 16, 845-874.

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Table 1. Simulation Results for the Fama-MacBeth and Modified FM tests.

T 60 120 240 360 60 120 240 360 1000 60 120 240 360 60 120 240 360 1000 Fama-MacBeth Modified FM Test 10% 5% 10% Panel A: Size of tests (m=0.0275) 0.043 0.090 0.057 0.111 0.053 0.106 0.042 0.086 0.044 0.086 0.054 0.102 0.049 0.112 0.053 0.098 Panel B: Size of tests (m=0.055) 0.047 0.100 0.045 0.100 0.049 0.097 0.049 0.093 0.055 0.093 0.049 0.092 0.036 0.082 0.058 0.105 0.051 0.091 0.044 0.097 Panel C: Power of tests (m=0.0275) 0.404 0.556 0.988 0.998 0.711 0.806 1.000 1.000 0.958 0.981 1.000 1.000 0.991 0.996 1.000 1.000 Panel D: Power of tests (m=0.055) 0.162 0.244 0.987 0.996 0.266 0.380 1.000 1.000 0.498 0.611 1.000 1.000 0.651 0.762 1.000 1.000 0.971 0.987 1.000 1.000 5%

29

Table 2. Sample Properties of Simulated Statistics (m=0.055).

Sample Mean Sample 5th 95th Variance Percentile Percentile Skewness Excess Kurtosis JB* Statistic p-value (JB)

T=60 Fama-MacBeth (H0) Modified FM (H0) Fama-MacBeth (HA) Modified FM (HA) T=120 Fama-MacBeth (H0) Modified FM (H0) Fama-MacBeth (HA) Modified FM (HA) T=240 Fama-MacBeth (H0) Modified FM (H0) Fama-MacBeth (HA) Modified FM (HA) T=360 Fama-MacBeth (H0) Modified FM (H0) Fama-MacBeth (HA) Modified FM (HA) T=1000 Fama-MacBeth (H0) Modified FM (H0) Fama-MacBeth (HA) Modified FM (HA)

0.020 -0.031 0.995 -4.377 -0.012 -0.040 1.356 -6.155 0.016 -0.055 1.938 -8.679 -0.027 -0.013 2.334 -10.557 -0.070 0.018 3.859 -17.534

1.031 1.017 1.031 1.216 1.014 1.010 1.028 1.195 0.984 0.973 0.990 1.135 0.938 1.032 0.938 1.166 0.968 0.993 0.973 1.190

-1.647 -1.718 -0.666 -6.227 -1.661 -1.614 -0.276 -7.925 -1.669 -1.644 0.224 -10.519 -1.554 -1.686 0.821 -12.383 -1.607 -1.595 2.339 -19.338

1.681 1.644 2.696 -2.630 1.625 1.650 2.987 -4.357 1.527 1.566 3.472 -6.998 1.583 1.640 3.916 -8.781 1.513 1.684 5.478 -15.776

-0.095 -0.040 -0.053 -0.200 0.015 0.109 0.052 -0.099 -0.163 -0.033 -0.144 -0.163 0.146 -0.005 0.159 -0.031 0.040 0.026 0.043 -0.076

0.071 -0.109 0.021 0.111 0.084 -0.050 0.100 -0.003 -0.067 0.084 -0.086 0.185 0.412 0.357 0.437 0.175 0.048 -0.116 0.047 -0.131

1.706 0.763 0.492 7.192 0.328 2.067 0.865 1.625 4.621 0.474 3.741 5.859 10.639 5.305 12.169 1.437 0.361 0.673 0.407 1.670

0.426 0.683 0.782 0.027 0.849 0.356 0.649 0.444 0.099 0.789 0.154 0.053 0.005 0.070 0.002 0.487 0.835 0.714 0.816 0.434

30

Table 3. Simulation Results for the FM and Modified FM tests.

T 60 120 240 360 60 120 240 360 1000 60 120 240 360 60 120 240 360 1000 Fama-MacBeth Modified FM Test 5% 10% 5% 10% Panel A: Rejection rate (Kan&Zhou, CAPM) (m=0.0275) 0.072 0.140 0.042 0.093 0.173 0.041 0.164 0.256 0.048 0.243 0.365 0.050 Panel B: Rejection rate (Kan&Zhou, CAPM) (m=0.055) 0.073 0.137 0.058 0.108 0.166 0.049 0.167 0.256 0.051 0.183 0.287 0.038 0.497 0.616 0.056 Panel C: Rejection rate (Jag&Wang, Non-CAPM) (m=0.0275) 0.134 0.220 0.593 0.223 0.335 0.871 0.409 0.552 0.992 0.566 0.681 1.000 Panel D: : Rejection rate (Jag&Wang, Non-CAPM) (m=0.055) 0.094 0.154 0.580 0.102 0.165 0.876 0.141 0.221 0.995 0.202 0.306 1.000 0.459 0.610 1.000

0.090 0.087 0.096 0.096 0.105 0.096 0.109 0.092 0.103 0.726 0.925 0.998 1.000 0.700 0.933 0.998 1.000 1.000

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Table 4. Estimation Results for the FM and Modified FM using US market data
T Sample (months) Mean (%) 120 240 336 120 240 120 216 120 156 0.553 0.497 0.583 0.577 0.512 0.440 0.600 0.448 0.771 FM test St. Error (%) t-statistic 0.535 0.351 0.305 0.451 0.297 0.457 0.370 0.387 0.449 1.035 1.415 1.915 1.278 1.728 0.964 1.621 1.158 1.718 Sample Mean (%) 0.527 0.13 0.058 0.026 -0.234 -0.267 -0.202 -0.494 -0.09 Modified FM test St. Error (%) t-statistic 0.298 0.193 0.183 0.235 0.168 0.243 0.230 0.239 0.294 1.769 0.671 0.319 0.112 -1.392 -1.099 -0.875 -2.072 -0.306

Start Jan-73

p-value 0.303 0.158 0.056 0.204 0.085 0.337 0.107 0.249 0.088

p-value 0.08 0.503 0.75 0.911 0.165 0.274 0.383 0.04 0.76

Jan-78 Jan-83 Jan-88

32