Pricing Model Performance and the Two-Pass Cross-Sectional Regression Methodology





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    • Kan is from the University of Toronto. Robotti is from the Federal Reserve Bank of Atlanta and EDHEC Risk Institute. Shanken is from Emory University and the National Bureau of Economic Research. We thank Pierluigi Balduzzi; Christopher Baum; Jonathan Berk; Tarun Chordia; Wayne Ferson; Nikolay Gospodinov; Olesya Grishchenko; Campbell Harvey (the Editor); Ravi Jagannathan; Ralitsa Petkova; Monika Piazzesi; Yaxuan Qi; Tim Simin; Jun Tu; Chu Zhang; Guofu Zhou; two anonymous referees; an anonymous Associate Editor; an anonymous advisor; seminar participants at the Board of Governors of the Federal Reserve System, Concordia University, Federal Reserve Bank of Atlanta, Federal Reserve Bank of New York, Georgia State University, Penn State University, University of New South Wales, University of Sydney, University of Technology, Sydney, and University of Toronto; as well as participants at the 2012 Utah Winter Finance Conference, the 2009 Meetings of the Association of Private Enterprise Education, the 2009 CIREQ-CIRANO Financial Econometrics Conference, the 2009 FIRS Conference, the 2009 SoFiE Conference, the 2009 Western Finance Association Meetings, the 2009 China International Conference in Finance, and the 2009 Northern Finance Association Meetings for helpful discussions and comments. Kan gratefully acknowledges financial support from the Social Sciences and Humanities Research Council of Canada and the National Bank Financial of Canada. The views expressed here are the authors' and not necessarily those of the Federal Reserve Bank of Atlanta or the Federal Reserve System.


Over the years, many asset pricing studies have employed the sample cross-sectional regression (CSR) R2 as a measure of model performance. We derive the asymptotic distribution of this statistic and develop associated model comparison tests, taking into account the impact of model misspecification on the variability of the CSR estimates. We encounter several examples of large R2 differences that are not statistically significant. A version of the intertemporal capital asset pricing model (CAPM) exhibits the best overall performance, followed by the Fama–French three-factor model. Interestingly, the performance of prominent consumption CAPMs is sensitive to variations in experimental design.