Assessing Asset Pricing Model Misspecification with a Returns Decomposition

Can Asset Pricing Models Price Idiosyncratic Risk in U.K. Stock Returns?

“…Chrétien and Cliff (2001) present a framework to evaluate the ability of a candidate asset pricing model at correctly pricing systematic risk and idiosyncratic risk. The key assumption is that the law of one price holds in financial markets.…”

“…Substituting into where E ( R it , ɛ t ) = 0. From , Chrétien and Cliff (2001) point out that any two portfolios on the minimum variance frontier R zt and R pt determines cov( m t , R it ) and so captures the role of systematic risk.…”

“…Chrétien and Cliff (2001) derive their decomposition of pricing errors by multiplying both sides of by y t and taking expectations, to give …”

“…Chrétien and Cliff (2001) develop a novel stochastic discount‐factor–based approach to examine how well asset pricing models handle idiosyncratic risk. (See Cochrane, 2005 and Ferson, 2003 for a review of the stochastic discount factor approach to asset pricing.)…”

“…Chrétien and Cliff (2001) build on the work of Roll (1977) and Hansen and Richard (1987) to provide a method to test the hypothesis that an asset pricing model assigns a zero price to idiosyncratic risk. The attraction of this approach is that it is independent of any asset pricing model and requires only that the law of one price holds in financial markets.…”