Misspecification and Weak Identification in Asset Pricing Frank Kleibergen and Zhaoguo Zhan
Coles Working Paper Series SPRING22-02, March 2022
Overview The widespread co-existence of misspecification and weak identification in asset pricing has overstated the performance of risk factors, jeopardizing the conventional Fama and MacBeth (1973) methodology. To solve the problem, we infer risk premia using a double robust Lagrange multiplier test. We show how the relative magnitudes of the misspecification J-statistic and the identification IS-statistic govern the identification and resulting appropriate interpretation of the risk premia. We revisit several prominent empirical applications and all specifications with one-to-six factors from the factor zoo of Feng, Giglio, and Xiu (2020) to emphasize the widespread occurrence of misspecification and weak identification.
46 | Working Papers
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