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A Reduced Rank Regression Approach to Tests of Asset Pricing[Note 1. This paper was presented at the ‘International Symposium on ...]
Author(s) -
Costa Michele,
Gardini Attilio,
Paruolo Paolo
Publication year - 1997
Publication title -
oxford bulletin of economics and statistics
Language(s) - English
Resource type - Journals
SCImago Journal Rank - 1.131
H-Index - 73
eISSN - 1468-0084
pISSN - 0305-9049
DOI - 10.1111/1468-0084.00055
Subject(s) - capital asset pricing model , econometrics , arbitrage pricing theory , economics , stock (firearms) , cross sectional regression , regression analysis , canonical correlation , factor analysis , regression , financial economics , statistics , mathematics , mechanical engineering , bayesian multivariate linear regression , engineering
Both the Arbitrage Pricing Theory (APT) and the Capital Asset Pricing Model (CAPM) place restrictions of the cross‐sectional variation of conditional expectations of asset returns and of macro indicators. We show that these restrictions imposed on the reference statistical models lead to special cases of the reduced rank regression model. The maximum likelihood problem is solved by canonical correlation analysis. Likelihood ratio tests about the number of factors underlying stock returns are straightforward to calculate, thus allowing discrimination between competing financial theories. Moreover LR tests on the relevance of each macroeconomic indicator within a chosen model can be implemented. Some of the tests are illustrated by an application to Italian stock market data.