General Tests of Latent Variable Models and Mean-Variance Spanning

Authors

  • WAYNE E. FERSON,

  • STEPHEN R. FOERSTER,

  • DONALD B. KEIM

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    • School of Business, University of Washington, School of Business Administration, University of Western Ontario, and the Wharton School, University of Pennsylvania, respectively. Formerly circulated under the title: “Tests of Asset Pricing Models with Changing Expectations.” We thank Phillip Braun, Mark Grinblatt, Robert Korajczyk, Andrew Lo, Craig MacKinlay, two anonymous referees, and seminar participants at Northwestern University and the Western Finance Association meetings for helpful comments. The research assistance of Raymond Chan and Edward Nelling is gratefully acknowledged. The first author acknowledges financial support from the Center for Research in Security Prices. The second author acknowledges financial support from the Plan for Excellence.


ABSTRACT

The methods of Gibbons and Ferson (1985) are extended, relaxing the assumption that expected returns are linear functions of predetermined instruments. A model of conditional mean-variance spanning generalizes Huberman and Kandel (1987). The empirical results indicate that more than a single risk premium is needed to model expected stock and bond returns, but the number of common factors in the expected returns is small. However, when size-based common stock portfolios proxy for the risk factors, we reject the hypothesis that four of them describe the conditional expected returns of the other assets.

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