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Handbook of Financial Econometrics and Statistics pp 1003–1023Cite as

Multifactor, Multi-indicator Approach to Asset Pricing: Method and Empirical Evidence

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Abstract

This paper uses a multifactor, multi-indicator approach to test the capital asset pricing model (CAPM) and the arbitrage pricing theory (APT). This approach is able to solve the measuring problem in the market portfolio in testing CAPM; and it is also able to directly test APT by linking the common factors to the macroeconomic indicators. Our results from testing CAPM support Stambough’s (Journal of Financial Economics, 10, 237–268, 1982) argument that the inference about the tests of CAPM is insensitive to alternative market indexes.

We propose a MIMIC approach to test CAPM and APT. The beta estimated from the MIMIC model by allowing measurement error on the market portfolio does not significantly improve the OLS beta, while the MLE estimator does a better job than the OLS and GLS estimators in the cross-sectional regressions because the MLE estimator takes care of the measurement error in beta. Therefore, the measurement error problem on beta is more serious than that on the market portfolio.

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Notes

  1. 1.

    Fogler et al. (1981) and Chen et al. (1983) indirectly link the factors extracted from the APT to economic indicators. Jöreskog and Goldberger (1975) have shown that this kind of indirect estimation method is not as efficient as the direct estimation method to be explored in this section.

  2. 2.

    Here, we use different terminologies in defining the factors and indicators compared with those used in traditional MIMIC model.

  3. 3.

    The terminologies stationary OLS and nonstationary OLS have been used by Friend and Westfield (1980). The GLS and MLE methods have been discussed by Litzenberger and Ramaswamy (1979).

  4. 4.

    See Chen (1981).

  5. 5.

    The similar results were also found in the Friend and Westfield’s (1980) study of co-skewness.

  6. 6.

    In his dissertation, Wei (1984) has shown that the “scree” test is a powerful test in identifying the number of relevant factors in the APT. By using simulation study, Wei has shown that Roll and Ross’s (1980) ML method in estimating factors are inferior to methods listed in Table 36.3.

    Table 36.3 Eigenvalue as a percentage of the first eigenvalue for 19 industry portfolios: 1963–1982
    Full size table
  7. 7.

    It is very expensive to run LISREL program, especially for more than two factor models.

  8. 8.

    The loss of the significance of the first factor risk premium is due to the multicollinearity problem.

    Table 36.5 Return-risk cross-sectional relationships of APT in the MIMIC model: 1963–1982
    Full size table
  9. 9.

    Only the one-factor APT is used to investigate the difference between the models shown in Table 36.4 and in Table 36.6.

    Table 36.6 Structural coefficients of the one-factor APT in the MIMIC model without market variables: 1963–1982
    Full size table
  10. 10.

    If we normalize the one-factor 11-indicator model for period 2 shown in Table 36.4b by setting b 1 = 1.00, it is easily seen that the b coefficients of one-factor model shown in Tables 36.4b and 36.6 column 2 are very similar.

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Authors and Affiliations

  1. Department of Finance and Economics, Rutgers Business School, Rutgers, The State University of New Jersey, 94 Rockefeller Rd. Levin Bldg., Piscataway, NJ, 08854, USA

    Cheng-Few Lee

  2. Hong Kong University of Science and Technology, Kowloon, Hong Kong

    K. C. John Wei

  3. Department of Finance, National Central University, Taoyuan, Taiwan

    Hong-Yi Chen

  4. Graduate Institute of Finance, National Chiao Tung University, Hsinchu, Taiwan

    Cheng-Few Lee

Authors
  1. Cheng-Few Lee
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  2. K. C. John Wei
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  3. Hong-Yi Chen
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Correspondence to Cheng-Few Lee .

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Editors and Affiliations

  1. Department of Finance and Economics, Rutgers Business School, Rutgers, The State University of New Jersey, Piscataway, New Jersey, USA

    Cheng-Few Lee

  2. Center for PBBEF Research, North Brunswick, New Jersey, USA

    John C. Lee

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Lee, CF., Wei, K.C.J., Chen, HY. (2015). Multifactor, Multi-indicator Approach to Asset Pricing: Method and Empirical Evidence. In: Lee, CF., Lee, J. (eds) Handbook of Financial Econometrics and Statistics. Springer, New York, NY. https://doi.org/10.1007/978-1-4614-7750-1_36

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  • DOI: https://doi.org/10.1007/978-1-4614-7750-1_36

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