The Robustness of the APT to Alternative Estimators

We test the robustness of the APT to two alternative estimation procedures: the Fama and MacBeth (1973) two-step methodology; and the one-step procedure due to Burmeister and McElroy (1988). We find that the APT is indeed sensitive to the chosen estimator and assumptions about the factor structure of stock returns. We believe that our findings have implications for the estimation of asset pricing models in general.     

Reports of beta's death are premature: Evidence from the UK

A number of authors have found that firm size and book-to-market-value capture the cross-sectional variation in average stock returns. More importantly, these variables have been shown to out-perform the CAPM's β coefficient in explaining the cross-section of US stock returns. However, these studies all employ variants of the two-step estimator due to Fama and MacBeth (Fama, E.F., MacBeth, J.D., 1973. Risk, return and equilibrium: Empirical tests. Journal of Political Economy 71, 607–636), which impose implicitly the restriction that idiosyncratic returns are uncorrelated. In this paper we use a one-step estimator due to McElroy et al. (McElroy, M.B., Burmeister, E., Wall, K.D., 1985. Two estimators for the APT model when factors are measured. Economics Letters 19, 271–275) and find a highly significant role for β risk in the UK stock market when we allow for correlation amongst idiosyncratic returns.     

Multivariate regression tests of the arbitrage pricing theory: The instrumental-variables approach

This article expands the theoretical basis upon which empirical testing of the arbitrage pricing theory (APT) rests. Specifically, it specifies linear restrictions for worlds in which the APT holds. These restrictions may, in principle, be tested. Since the regressors in the model are only “noisy” proxies for a specific linear transformation of the factors or mimicking portfolios, testing regressions suffer from an errors-in-variables problem. The standard econometric treatment for this problem is the instrumental-variables approach. A size-based example is employed to compare the test results derived from the instrumental-variables approach to those obtained via the ordinary least squares (OLS) method. The results from both methods cannot reject a two-factor APT for the size-sorted portfolio sample. The authors appreciate the helpful comments of Edwin Burmeister, Raymond Chiang, Steve Pruitt, participant at the 1989 Western Finance Association annual meetings, Indiana University, and University of Miami, and especially Shmuel Kandel.     

Fundamental Economic Variables,Expected Returns,and Bond Fund Performance

In this article, we develop relative pricing (APT) models that are successful in explaining expected returns in the bond market. We utilize indexes as well as unanticipated changes in economic variables as factors driving security returns. An innovation in this article is the measurement of the economic factors as changes in forecasts. The return indexes are the most important variables in explaining the time series of returns. However, the addition of the economic variables leads to a large improvement in the explanation of the cross-section of expected returns. We utilize our relative pricing models to examine the performance of bond funds.     

Estimation of the underlying structure of systematic risk with the use of principal component analysis and factor analysis

We present an improved methodology to estimate the underlying structure of systematic risk in the Mexican Stock Exchange with the use of Principal Component Analysis and Factor Analysis. We consider the estimation of risk factors in an Arbitrage Pricing Theory (APT) framework under a statistical approach, where the systematic risk factors are extracted directly from the observed returns on equities, and there are two differentiated stages, namely, the risk extraction and the risk attribution processes. Our empirical study focuses only on the former; it includes the testing of our models in two versions: returns and returns in excess of the riskless interest rate for weekly and daily databases, and a two-stage methodology for the econometric contrast. First, we extract the underlying systematic risk factors by way of both, the standard linear version of the Principal Component Analysis and the Maximum Likelihood Factor Analysis estimation. Then, we estimate simultaneously, for all the system of equations, the sensitivities to the systematic risk factors (betas) by weighted least squares. Finally, we test the pricing model with the use of an average cross-section methodology via ordinary least squares, corrected by heteroskedasticity and autocorrelation consistent covariances estimation. Our results show that although APT is very sensitive to the extraction technique utilized and to the number of components or factors retained, the evidence found partially supports the APT according to the methodology presented and the sample studied.     

Equilibrium exchange rates in Central and Eastern Europe: A meta-regression analysis

This paper analyses the ever-growing literature on equilibrium exchange rates in the new EU member states of Central and Eastern Europe in a quantitative manner using meta-regression analysis. The results indicate that the real misalignments reported in the literature are systematically influenced, inter alia, by the underlying theoretical concepts (Balassa–Samuelson effect, behavioral equilibrium exchange rate, fundamental equilibrium exchange rate) and by the econometric estimation methods. The important implication of these findings is that a systematic analysis is needed in terms of both alternative economic and econometric specifications to assess equilibrium exchange rates.     

Economic forces and seasonality in secirity returns

This article finds strong seasonal behavior in the innovations for three Canadian macroeconomic variables (industrial production, unexpected inflation and GDP). An APT model is estimated as a restricted nonlinear multivariate regression system using seven macroeconomic variables, various residual market factor (RMF) proxies, and the returns on fifty size related portfolios of equities that traded on the Toronto Stock Exchange (TSE). As in Chen, Roll and Ross (1986), five macrofactors (lagged industrial production, lagged GDP, term structure, unexpected inflation, and risk premium) have significantly priced risk premia. The risk premia are insignificant for RMF based on two value weighted indices, and marginally significant (0.10 level) for the RMF based on an equally weighted index, which is somewhat consistent with McElroy and Burmeister (1988) and Brown and Otsuki (1989). The significance of the RMF risk premium appears not to be robust to whether portfolios or individual securities are used in the estimations. The significance of the estimated risk premia for the macrofactors also appear not to be robust to the number of portfolios (equations) used in the estimations. Unlike the risk premia estimates for the RMF, those for the other macrofactors are generally unaffected by the inclusion of a January dummy. This implies that the January seasonal remains a market phenomenon that requires further study.     

Deriving the arbitrage pricing theory when the number of factors is unknown

This paper examines the use of proxies (or reference variables) for the true factors in the arbitrage pricing theory (APT). It generalizes other authors' existing work and shows that, when there are more reference variables than the true factors, the APT still holds. The possibility of fewer reference variables than the true factors is also considered, but the APT is not shown to hold, in the same sense, for this case. This work builds on an earlier paper by Ingersoll (Ingersoll J 1984 J. Finance 39 1021-39), and our propositions can be thought of as specializations of his theorems. Similar to Nawalkha (Nawalkha S 1997 J. Financial Economics 46 357-81), our work does not use the mathematics of Hilbert and Banach spaces and, thus, is open to a much wider audience. The practical implication of our results is that model builders should be generous with the number of factors they use, as excessively parsimonious models suffer from inaccuracy.     

Diversification of Macroeconomic Risk and International Integration of Capital Markets: The Case of Mexico

This article tests the arbitrage pricing theory in the contextof the unstable macroeconomic years in Mexico, 1977–87.Using information on returns on assets available to domesticinvestors—primarily stocks traded at the local stock exchange—anattempt is made to ascertain the extent to which these assetshave offered premia for a set of proposed sources of risk. Thepervasive factors that play an important role in asset pricingin Mexico are unexpected inflation, unexpected money growth,innovations in the Standard & Poor's 500 price series, andinnovations in the dollar oil price. A residual market factoris obtained, using the McElroy and Burmeister model. Given thatthese risks get premia over and above the riskless rate, expectedrates of return in Mexico have been higher during the yearsof erratic macroeconomic conditions. Mexico is not consideredto be well integrated with the international capital marketsbecause local sources of risk—such as inflation—arenot priced in the United States, whereas international sourcesof uncertainty—such as oil price shocks—are pricedlocally but not in the United States.     

Dynamic stochastic general equilibrium (DSGE) modelling in practice: identification,estimation and evaluation

In recent years, dynamic stochastic general equilibrium (DSGE) models have come to play an increasing role in central banks, as an aid in the formulation of monetary policy (and increasingly after the global crisis, for maintaining financial stability). DSGE models, compared to other widely prevalent econometric models (such as vector autoregressive or large-scale econometric models), are less a-theoretic and with secure micro-foundations based on the optimizing behaviour of rational economic agents. Additionally, the models in spite of being strongly tied to theory, can be ‘taken to the data’ in a meaningful way. A major feature of these models is that their theoretical underpinnings lie in what has now come to be called as the New Consensus Macroeconomics (NCM). This paper concentrates on the econometric structure underpinning such models. Identification, estimation and evaluation issues are discussed at length with a special emphasis on the role of Bayesian maximum likelihood methods.     

An intertemporal equilibrium beta pricing model

This article develops an intertemporal, discrete-time, competitiveequilibrium version of the arbitrage pricing theory, (APT) andexplores the econometric implications of this model under variousrestrictions on investor preferences and on the dynamic behaviourof dividends. We describe conditions under which the econometrictechnique typically used for estimating and testing the APTcan be shown to be consistent with our economic model. We relateour intertemporal version of the APT to the static APT and toMerton's intertemporal capital asset pricing model.     

Gaussian models for Euro high grade government yields

This paper tests affine, quadratic and Black-type Gaussian models on Euro area triple A Government bond yields for maturities up to 30 years. Quadratic Gaussian models beat affine Gaussian models both in-sample and out-of-sample. A Black-type model best fits the shortest maturities and the extremely low yields since 2013, but worst fits the longest maturities. Even for quadratic models we can infer the latent factors from some yields observed without errors, which makes quasi-maximum likelihood (QML) estimation feasible. New specifications of quadratic models fit the longest maturities better than does the ‘classic’ specification of Ahn et al. [2002. ‘Quadratic Term Structure Models: Theory and Evidence.’ The Review of Financial Studies 15 (1): 243–288], but the opposite is true for the shortest maturities. These new specifications are more suitable to QML estimation. Overall quadratic models seem preferable to affine Gaussian models, because of superior empirical performance, and to Black-type models, because of superior tractability. This paper also proposes the vertical method of lines (MOL) to solve numerically partial differential equations (PDEs) for pricing bonds under multiple non-independent stochastic factors. ‘Splitting’ the PDE drastically reduces computations. Vertical MOL can be considerably faster and more accurate than finite difference methods.     

Alternative Models for Estimating the Cost of Equity Capital for Property/Casualty Insurers

This paper estimates the cost of equity capital for Property/Casualty insurers by applying three alternative asset pricing models: the Capital Asset Pricing Model (CAPM), the Arbitrage Pricing Theory (APT), and a unified CAPM/APT model (Wei (1988). The in-sample forecast ability of the models is evaluated by applying the mean squared error method, the Theil U2 (1966) statistic, and the Granger and Newbold (1978) conditional efficiency evaluation. Based on forecast evaluation procedures, the APT and Wei's unified CAPM/APT models perform better than the CAPM in estimating the cost of equity capital for the PC insurers and a combined forecast may outperform the individual forecasts.     

The attributes,behavior, and performance of U.S. mutual funds

This article examines the risk and return characteristics of U.S. mutual funds. We employ an equilibrium version of the Arbitrage Pricing Theory (APT) and a principal-components-based statistical technique to identify performance benchmarks. We also consider the Capital Asset Pricing Model (CAPM) as an alternative. We implement a procedure for overcoming the rotational indeterminacy of factor models. This procedure is a hybrid of statistical factor estimation and prespecification of factors. We estimate measures of timing ability for the CAPM and extend it to the APT. We find that this timing test is misspecified due to noninformation-based changes in mutual fund betas. We develop a modification of the timing measure that, under certain conditions, distinguishes true timing ability from noninformation-based beta changes.     

An explicit bound on individual assets' deviations from APT pricing in a finite economy

Ross's Arbitrage Pricing Theory (APT) is a tractible and reasonable alternative to the mean-variance model. Nonetheless, understanding of the theory has been obscured by the complexity of the sequence economy models used for motivation. By contrast, we give a simple and direct derivation of the APT in a finite economy. Using an explicit bound on the deviations from APT prices across assets, a coarse calculation shows that theoretical deviations from APT pricing are negligible in our economy.     

Share Prices and Macroeconomic Factors

The APT with macroeconomic factors put forward by Chen, Roll and Ross (1986) was tested using monthly Australian sectoral share-price indexes for 1980–1994. The inflation rate was found to be consistently priced. The significance of other factors was found to depend on the choice of sample period and estimation method. The model was compared to both an APT with artificial factors and the CAPM. Both versions of the APT were found to clearly out-perform the CAPM but neither version of the APT was clearly superior to the other in terms of both within- and out-of-sample explanatory power.     

An Asset-Pricing Theory Unifying the CAPM and APT

This study shows that the competitive-equilibrium version of the APT may be extended to develop an exact model if idiosyncratic risks obey the Ross separating distribution. The results indicate that one only need add the market portfolio as an extra factor to the factor model in order to obtain an exact asset-pricing relation. Thus, this study presents an extension and integration of the CAPM and APT. The “empirical” APT is also generalized to allow for some factors to be omitted from the econometric model employed to test the theory. The developed model is extremely robust and may be reduced to the CAPM or expanded to approximate Ross's APT depending upon the number of omitted factors. Further, the importance of the market portfolio is shown to be a monotonic increasing function of the number of omitted factors. Finally, the study demonstrates that, in a finite economy, the pricing-error bound of the Ross APT in a correlated-residuals factor structure is an increasing function of the absolute value of market-residual beta, rather than the weight of the asset in the market portfolio as is the case of uncorrelated factor residuals. However, under the normality assumption, the pricing error becomes an extra component related to the market-portfolio factor, and the exact asset-pricing relation is once again obtained.     

Collective Bargaining and Cost Accounting: The Case of the US Men's Clothing Industry

The attributes and rationales of modern cost accounting procedures are not unequivocal. Some scholars underscore the adversarial relationship between accounting and labour (Bougen, 1989; Owen and Lloyd, 1985; Ogden and Bougen, 1985) while others contend that accounting data were used as much for social, political and ideological purposes as for efficiency concerns (Hopper and Armstrong, 1991; Ezzamel et al., 1990; Hoskin and Macve, 1988a and 1988b; Stewart, 1992). Alternatively, several researchers have re-examined the origins of cost accounting and more recent costing developments (Fleischman and Parker, 1991; Fleischman and Tyson, 1993; and Tyson, 1990 and 1992). The present paper further explores the development of modern cost accounting practice. It presents a detailed analysis of the US men's clothing industry between 1919 and 1926 and assesses over 1,200 arbitration decisions to determine how piece rates, production standards and standard costs were developed, implemented and carried out in practice. It finds that collective bargaining and compulsory arbitration significantly moderated these procedures such that workers and owner/managers received tangible economic benefits.     

Security factors as linear combinations of economic variables

A new framework is proposed to find the best linear combinations of economic variables that optimally forecast security factors. In particular, we obtain such combinations from Chen et al. (Journal of Business 59, 383–403, 1986) five economic variables, and obtain a new GMM test for the APT which is more robust than existing tests. In addition, by using Fama and French's (1993) five factors, we test whether fewer factors are sufficient to explain the average returns on 25 stock portfolios formed on size and book-to-market. While inconclusive in-sample, a three-factor model appears to perform better out-of-sample than both four- and five-factor models.     

Powerful CEOs,cash bonus contracts and firm performance

We investigate whether powerful chief executive officers (CEOs) influence the conditions of their cash bonus contracts. Specifically, we examine (i) the association between CEO power and the proportion of ex-ante cash bonus to base salary (bonus ratio), (ii) the association between CEO power and the relative use of non-financial to financial performance targets in cash bonus contracts, and (iii) the performance consequences of incorporating non-financial targets in cash bonus contracts. Results show that powerful CEOs are associated with greater ex-ante bonus ratios and higher proportions of non-financial performance targets compared to less powerful CEOs. Furthermore, the use of quantitative and corporate social responsibility (CSR)-related non-financial performance targets is positively associated with subsequent firm performance, and the use of undefined non-financial performance targets is negatively associated with subsequent firm performance. These results are robust to alternative econometric specifications and variable definitions.