Specification Errors of Asset Pricing Models for a Market Characterized with Large Capitalization Firms

Abstract

The evaluation for the specification errors of asset pricing models is conducted using size-BM, size-MOM and industry portfolios (21) for Finnish stock market. The Finnish market is taken as a test case for equity markets where few firms dominate the total market capitalization. We report diverging risk-returns tradeoffs for the average tendencies of the stocks and for the actual growth in them. The results suggest the poor cross-sectional ability of unconditional CAPM is improved if the parameters of the stochastic discount factor (SDF) are allowed to vary through time. Nonetheless, the Carhart (1997) model SDF produces the lowest Hansen and Jagannathan (1997) distance for stock returns across all tested specifications. The Fama and French (1993) model augmented with macro variables, and January scaled CAPM produce matching performances to Carhart model with equal and capitalized weighting respectively. The evidence is stable under the employed diagnostics checks.