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Why is it important?
This paper introduces a novel reverse testing approach to test asset pricing models. Most research use realized returns as proxies for expected returns. Our reverse testing approach takes the works of Campbell and Hentschel (JFE 1992), and Guo and Whitelaw (JF 2006) one step further and use the insight that each pricing model for expected returns implies a certain specification for the realized returns.
Perspectives
Although we demonstrate the reverse (or flipped) testing with the Merton (1980) model with only one asset (market), it should be usable for other models and assets as well.
Professor Mika Vaihekoski
Turun Yliopisto
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This page is a summary of: Expected and realized returns in conditional asset pricing models: A new testing approach, Journal of Empirical Finance, June 2019, Elsevier,
DOI: 10.1016/j.jempfin.2019.04.001.
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