Journal Article

Filtering Returns for Unspecified Biases in Priors when Testing Asset Pricing Theory

Peter Bossaerts

in The Review of Economic Studies

Published on behalf of Review of Economic Studies Ltd

Volume 71, issue 1, pages 63-86
Published in print January 2004 | ISSN: 0034-6527
Published online January 2004 | e-ISSN: 1467-937X | DOI: http://dx.doi.org/10.1111/0034-6527.00276
Filtering Returns for Unspecified Biases in Priors when Testing Asset Pricing Theory

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Procedures are presented that allow the empiricist to estimate and test asset pricing models on limited-liability securities without the assumption that the historical payoff distribution provides a consistent estimate of the market's prior beliefs. The procedures effectively filter return data for unspecified historical biases in the market's priors. They do not involve explicit estimation of the market's priors, and hence, economize on parameters. The procedures derive from a new but simple property of Bayesian learning, namely: if the correct likelihood is used, the inverse posterior at the true parameter value forms a martingale process relative to the learner's information filtration augmented with the true parameter value. Application of this central result to tests of asset pricing models requires a deliberate selection bias. Hence, as a by-product, the article establishes that biased samples contain information with which to falsify an asset pricing model or estimate its parameters. These include samples subject to, e.g. survivorship bias or Peso problems.

Keywords: C52; G12

Journal Article.  11675 words.  Illustrated.

Subjects: Economics ; Econometric Modelling

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