DP3058 An Investment-Growth Asset Pricing Model

Author(s): Qing Li, Maria Vassalou, Yuhang Xing
Publication Date: November 2001
Keyword(s): GMM
JEL(s): G12
Programme Areas: Financial Economics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=3058

In this paper we present a simple model where asset returns are functions of multiple investment growth rates. The model is tested for its ability to price the 25 Fama-French portfolios using the Generalized Methods of Moments (GMM) methodology, as well as Fama-MacBeth cross-sectional regressions. Comparisons on the basis of several metrics with other models, such as the CAPM, the Fama-French (1993) model and Cochrane's (1996) model, reveal that it consistently outperforms the CAPM and Cochrane's model. It also outperforms the Fama-French model in several tests. Our model can explain a significantly larger proportion of the cross-sectional variation in the 25 Fama-French portfolios than the Fama-French model does. Specification tests in the context of GMM and the Fama-MacBeth regressions show that in the presence of the investment growth factors included in our model, the size and book-to-market characteristics lose their ability to explain asset returns. Our model is successful in pricing size- and book-to-market- sorted portfolios, although it includes exclusively macroeconomic variables as factors.