Risk and Return in an Equilibrium APT - Application of a New Test Methodology

An asymptotic principal-components technique is used to estimate the pervasive factors influencing asset returns and to test the restrictions imposed by static and intertemporal equilibrium version of the arbitrage pricing theory (APT) on a multivariate regression model. The techniques allow for fairly arbitrary time variation in risk premiums. Large cross-sectional samples (between 1487 and 1745 firms), both grouped into size-based portfolios and at the individual security level, are used to test the model. Tests are performed using disaggregated data by placing prior restrictions on the covariance matrix of residuals. The techniques are also applied to the capital asset pricing model (CAPM), using standard proxies for the market portfolio. It is found that the APT provides a better description of the expected returns on assets than the CAPM. However, some statistically reliable mispricing of assets by the APT remains.