On Model Testing in Financial Economics


Corresponding author: Johnson Graduate School of Management, Cornell University, 451 Sage Hall, Ithaca, NY 14853; Phone: (607) 255-4729; E-mail: raj15@cornell.edu.


This paper discusses the two different contradicting philosophies for testing models in financial economics (asset pricing, corporate finance, and market-microstructure) using linear regression. We synthesize these two contradicting approaches, document the errors that may occur in the existing estimation methodologies, and suggest a modified procedure that avoids these errors.