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Three essays on empirical asset pricing

Xiaoyan Zhang, 2002
Faculty Advisor: Robert J. Hodrick


The dissertation contains three chapters.

The first chapter (co-authored with Hodrick) evaluates the specification errors of several empirical asset pricing models that have been developed as potential improvements on the CAPM. We use the methodology of Hansen and Jagannathan (1997), and the test assets are the US 25 Fama-French (1993) equity portfolios sorted on size and book-to-market ratio, and the Treasury bill. We allow the parameters of each model's pricing kernel to fluctuate with the business cycle. While we cannot reject correct pricing for Campbell's (1996) model, stability tests indicate that the parameters may not be stable. A robustness test also indicates that none of the models correctly price returns that are scaled by the term premium.

The second chapter studies the cross-sectional pricing performances of several international asset pricing models. The comparison metric is the Hansen-Jagannathan distance, and the base assets are size and book-to-market portfolios from the US, the UK and Japan. When betas and risk premiums are constant over the business cycles, none of the models can pass the specification test. By allowing time-varying betas and risk premiums, most of the conditional models can capture the cross-sectional return spreads and can pass the test, because the base assets have different sensitivities to the time-varying risk premiums. The Fama-French factors are redundant in conditional models. Finally, exchange risk exposures contribute significantly to the international asset returns, and the conditional International CAPM with exchange risk performs the best. The market integration hypothesis is also supported.

The third chapter (coauthored with Cavaglia, Hodrick and Vardim) explores the ability of several international asset-pricing models to explain the average returns on a set of global industry portfolios. The general noisiness of the data makes it difficult to accurately estimate average returns. Thus, all of the international models are able to capture the cross-sectional industry return spreads. The methodology also results in an investment strategy that maximally exploits the benchmarks' mispricings. When there is no short-selling constraint, investing in the industry portfolios provides big diversification benefit, but the benefit becomes marginal when there is a short-selling

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