Nonlinearity and Endogeneity in Macro-Asset Pricing


Linear asset-pricing relations, with macr oeconomic factors as state variables, have found wide use in empirical finance. Applications of such relations range from academic studies of market efficiency and market anomalies to practical uses such as risk management and estimation of the cost of capital. These applications make two key assumptions: that the relationship is exclusively linear , and that the macr oeconomic factors ar e exogenous to returns. For the set of macr ofactors commonly used in these applications, both assumptions run counter to economic intuition. We set out to demonstrate that they ar e also counter to empirical evidence. We carry out this task using tests for linear and nonlinear Granger causality. We find linear and nonlinear feedback between stock returns and commonly used macr oeconomic pricing factors. We also find linear and nonlinear feedback between residuals from linear pricing relations and returns. In addition, there is little evidence to suggest that neglected autor egressive or autor egressive conditionally heter oskedastic dynamics ar e responsible for these findings, implying that the underlying dynamics ar e complicated. Thus, linear asset-pricing relations omit interesting and potentially useful aspects of the relationship between stock returns and the macr oeconomy. Acknowledgments. We wish to thank the participantsat earlier presentationsof this paper for their helpful comments.We also wish to thank Pedro de Lima,Robert Flood, Ted Jaditz, Jonathan Jones, FrancisLongstaf, Bruce Mizrach,and anonymousreferees for comments.We also thank Janet Shelley for her assistancewith the manuscript. Keywor ds. Grangercausality;financialmarkets; arbitragepricing theory 1Versions of this paperwere presented for the EconomicsDepartmentat Southern MethodistUniversity,the Time SeriesGroup at the SantaFe Institute, the Chaos and NonlinearDynamics StudyGroup at the U.S. Bureau of Labor Statistics, and the 1994 North AmericanSummer Meetingsof the EconometricSociety. c © 1998 by the MassachusettsInstituteof Technology Studiesin NonlinearDynamicsand Econometrics,October 1997, 2(3): 61–76

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@inproceedings{Hiemstra1995NonlinearityAE, title={Nonlinearity and Endogeneity in Macro-Asset Pricing}, author={Craig Hiemstra and Charles L. Kramer}, year={1995} }