Journal of Financial Economics 14 (1985) 359-375.

North-Holland

A MONTE CARLO INVESTIGATION OF THE ACCURACY

OF MULTIVARIATE CAPM TESTS*

Christine E. AMSLER and Peter SCHMIDT

Michigan State Universrty. East fusing, MI 48824, USA

Received September 1984, final version received January 1985

In a multivariate regression model relating individual returns to the market return, CAPM implies
non-linear restrictions on the parameters. Several asymptotically valid tests of these restrictions
have been suggested. The existing Monte Carlo evidence shows that some of these tests are
unreliable for reasonable sample sizes, but does not indicate well which tests are reliable. This
paper reports the results of an extensive Monte Carlo experiment. Shankens CSR test and Jobson
and Korkies corrected likelihood ratio test are quite accurate in all cases we consider.

1. Introduction
Empirical testing of the capital asset pricing model (CAPM) has a long
history. The most widely known studies are tests of the Sharpe (1964)-Lintner
(1965) CAPM by Black, Jensen and Scholes (1972), Fama and MacBeth
(1973), Blume and Friend (1973) and Friend, Westerfield and Granito (1978),
and a test of the Merton (1973) continuous time CAPM by Jensen (1972).
These studies employ cross-sectional regressions of mean returns on estimated
betas, and suffer from a measurement error problem because of their reliance
on estimated (rather than actual) betas. To avoid this measurement error
problem, recent tests of CAPM have been based on estimation of the multi-
variate regression model. As noted by Gibbons (1980,1982), the linearity of the
relationship between expected return and risk implies a set of non-linear
restrictions on the parameters of the multivariate regression model relating
individual returns to the market return. These non-linear restrictions can be
tested in a variety of standard ways. Gibbons considers the Wald (W) test and
the likelihood ratio (LR) test, while Stambaugh (1981,1982) suggests the
Lagrange Multiplier (LM) test. All of these tests are valid asymptotically (as
the number of time-series observations increases), but they may differ substan-
tially from each other, and from their asymptotic distributions, even when the
sample size is moderately large. The existing Monte Carlo evidence, reported
by Gibbons (1982), Stambaugh (1982), Jobson and Korkie (1982), and

*The authors thank Rex Thompson, the referee, for helpful comments and suggestions

0304-405X/85/$3.300 1985, Elsevier Science Publishers B.V. (North-Holland)

360 C.E. Anuler und P. Schmidr, Monte Cur10 ano!vsis oj CA PM tests

Ma&inlay (1984), appears to favor the LM test or a corrected version of the

LR test.
In important recent papers, Shanken (1982b, 1985) has related these maxi-
mum-likelihood based tests to the earlier cross-sectional regression methods,
and proposed a new test. He defines a cross-sectional regression (CSR) test by
a modification of Hotellings T2 test, and shows that the LR and LM tests
bear a simple relationship to the CSR test. However, despite employing some
corrections based on small-sample distribution theory, the CSR test is still
valid only asymptotically. [For a good discussion of the nature of Shankens
approximation, see Roll (1985).]
The purpose of this paper is to provide Monte Carlo evidence on the
accuracy of the W, LR, LM and CSR tests. The earlier Monte Carlo experi-
ments (cited above) have shown that the asymptotic distributions of W, LR
and LM may be unreliable, even for moderately large sample sizes. However,
these experiments have been less successful in revealing the small-sample
distribution of the test statistics than might be hoped, mainly because (for
reasons of computational cost) they have used too few replications per experi-
ment. The experiments cited above all used between 200 and 300 replications
per experiment. By contrast, in most of our experiments we use 4000 repli-
cations. We should be able to detect much smaller deviations of the actual
probability of rejection from the nominal level (or, more generally, much
smaller deviations of the actual distribution of the test statistic from the
asymptotic distribution) than was possible in the earlier experiments.
The plan of the paper is as follows. Section 2 presents the tests which are to
be compared. Section 3 describes the set-up of the experiment, while the results
for the various tests are given in section 4. Section 5 briefly discusses some
additional results on alternative estimators calculated in the experiments.
Finally, section 6 gives our conclusions. Our basic conclusion is that Shankens
CSR test and Jobson and Korkies corrected LR test dominate the other tests
which we consider.

2. The model and the tests

Using the notation of Stambaugh (1982), we let K be the number of assets

and T be the number of time-series observations on each asset and on the
market index, and we write the market regression equations as

r, = i,a, + r,& + Ei, i=1,2 Y-*-FK. (1)

Here rj, r,,, and .si are T x 1 vectors containing observations on the return on
asset i, observations on the return on the market index, and regression
disturbances, respectively. Also i, is a TX 1 vector of ones, while ai and pi
are scalar parameters. Now let (Y and /3 be K X 1 vectors made up of the (Y,
 C. E. Am&r and P. Schmidt, Monte Curlo unu~vs~so/ CA PM tests 361

and pi, and let p be the K x 1 vector whose ith element is E(r,). The CAPM
implies linearity between p and p; p= yii, + y2/3 for some (scalar) yi and y2.
This in turn implies that

a = yliK + vz*p, (2)

where

Y;=~Z-pm with p,=E(r,,,).

Eq. (2) is a set of K - 2 restrictions on the parameters of (1) since 2K

parameters ((Y, p) are replaced by K + 2 parameters (yi, y:, p). This is the set
of restrictions tested by Stambaugh. We refer to (1) plus (2) as the FM [after
Fama and MacBeth (1973)] specification.
In addition, the mean-variance efficiency of rm implies that yz = pL, - yi, so
that y; = -yl. Thus (2) is replaced by

a= yl(iK- P). (3)

This is a set of K - 1 restrictions on the parameters of (1) since 2K parame-

ters (a, fi) are replaced by K + 1 parameters (yi, p). This is the set of
restrictions tested by Gibbons. We refer to (1) plus (3) as the BJS [after Black,
Jensen and Scholes (1972)] specification.
For each specification, we will consider seven tests of the CAPM restrictions.
We will discuss these first for the FM specification, that is, for the K - 2
restrictions implied by (2). We begin with the Shanken CSR test. Assume
T > K. Let & and j? be the estimates of cr and j!l from application of OLS to
(1). Let 2 be the K X K estimated covariance matrix of the errors, calculated
as the matrix of sums of squares and cross-products of the OLS residuals,
divided by T. Define 7 as the K x 1 vector of mean returns, and 2 = (i,, b), a
K x 2 matrix. Let 4i and T2 be the estimates in a GLS second-pass regression
of F on a constant and j%

f= (Y1,Y2)= (pp~)-ppr;.
(4)
Let e = ? - _?f denote the K X 1 vector of residuals from this regression, and
define s* as the sample variance of r,. Then we have the statistic

Q* = T&-e/[l + T;/s*]. (5)

Shanken shows that Q* + xi_* as T -+ 00 [under the null hypothesis that (2)
holds], and we will refer to the Q* test as the test which compares (5) to a
critical value of xi_*.
362 C. E. Amsler and P. Schmidt, Monte Carlo analysis of CA PM tests

Alternatively, a degrees of freedom correction can be made in estimating 1.

If we replace 2 in (5) by Z&/( T - 2) the unbiased estimate of 2, we obtain
QA = Q*( T - 2)/T, which also -+ x;_~ as T + 00. This defines the QA test.
However, following Shanken (1984) we also consider comparing QA not to
XL_? but rather to the critical points obtained from Hotellings F2. This leads
us to the statistic

CSR= (K:-2;;f QA, 2)

to be compared to the critical point of FK_2,T_K+1. This defines the CSR

test.
The QA, Q* and CSR tests are all valid only asymptotically, and asymptoti-
cally they are equivalent. However, for finite samples the Q* test will reject
more oftenthan the QA test, and the QA test will reject more often than the
CSR test. [To see this last fact, note that comparing QA to xi_2 is equivalent
to comparing QA/(K-2) to FK_2,m. The CSR test is more conservative
because the statistic is made smaller by multiplying by (T - K + l)/(T - 2)
which is less than one for K > 3, and also because the critical points of
F K-2,T-K+1 exceed those of FK_2,m.]
The LR and LM tests discussed by Stambaugh (1982) are also related to Q*.
As Shanken (1982a) shows,

LR = T ln(1 + Q*/T),

while

LM = Q*/(l + Q*/T).

The LR or LM test is then defined by comparing LR or LM to the critical

points of x&2.
Jobson and Korkie (1982) modify the LR test (for the Sharpe-Lintner
model) by multiplying it by a small-sample correction factor due to Bartlett
(1938). In the present case, this amounts to replacing T in the definition of LR
by T - 2 - K/2, thus reducing the value of the test statistic. We will refer to
the test which compares this adjusted LR statistic to the critical points of xi-2
as the LR* test.
Finally, we have the Wald (W) test. This test statistic is as defined by
Stambaugh [1981, p. 39, eq. (22)], with the restrictions expressed in the
following explicit form:

(~2-~*)(Pj-B,)-(P2-P1)(~j-~1)=", j=3 ,..., K. (7)

 C. E. Amsler and P. Schmidt, Monte Carlo analysw of CA PM tests 363

Such an explicit statement is necessary because the Wald test is not invariant
(in finite samples) to the way in which the restrictions are written; only the
Wald test, among the tests we consider, has this defect. The Wald test statistic
is calculated as a quadratic form involving the amounts by which the restric-
tions (7) fail in the unrestricted &,j?. (It is not known to be related in any exact
functional way to Q*.) Its asymptotic distribution is x$_~.
We now briefly discuss the tests for the BJS restrictions as given in (3). We
begin again with Shankens tests. Let 6, j?, and 2 be as before. Let ti be the
estimate in a GLS second-pass regression of &, on (1 - &):

~,=,e-l(iK-~)/(iK-~),e-l(iK-8), (8)

the GLS version of the BJS estimate. Define e = & - Pl(iK - 8) and s2 as
above. Then the Q* test compares

Q* =Z-&e/[l +(i;,-T1)/s2]

to a critical point of xi-i, its asymptotic distribution. (Here_?,,, is the mean

market return.) The QA test is identical except that, in Q*, I: is replaced by
the unbiased estimator &/( T - 1). The CSR test involves comparing CSR
= (T- K)Q/(K- l)(T- 2) to a critical point of FK_l,T_K. The LR and
LM test statistics are related to Q* exactly as before. The LR* test replaces
T in the definition of LR by T - 1.5 - K/2. Finally, the Wald statistic is based
on the (K - 1) restrictions written as a,(1 - pi) - aj(l - &) = 0, j =
2,3,. . . ( K, but is otherwise identical to the Wald test as given by Gibbons
(1980, app. D).
All of the tests described so far are based on the two-step (Newton-
Raphson) estimators rather than on the actual MLEs. [Shanken (1982b) and
Ma&inlay (1984) have shown that the GLS two-step estimates pi and y2
above are in fact the same as the Newton-Raphson estimates.] Based on the
previous results of Stambaugh (1981), it seems unlikely to make much dif-
ference whether the tests are based on the Newton-Raphson estimates or on
the true MLEs, and most empirical work has avoided the MLEs because they
were considered harder to calculate. However, recent papers by Kandel(l984)
and Shanken (1983) have shown that the true MLEs can be calculated from
the Newton-Raphson estimates, by solving a quadratic equation, but without
iteration, as was previously necessary. This essentially removes the computa-
tional barrier to the use of the actual MLEs. Therefore we will also consider
the Q, Q*, CSR, LR, LM and LM* tests based on the actual MLEs. These are
still defined exactly as above, except that we use not pi and A as given in (4),
but rather the MLEs. [For the BJS model, we use the MLE of yi instead of pi
as given in (8).] Note that there is no Wald test based on the MLEs, since the
Wald test uses only the market-model estimates of a and 8.
364 C. E. Amsler und P. Schmidl. Monte Carlo anulysis o/ CA PM nests

3. Design of the Monte Carlo experiment

Roughly speaking, the design of our Monte Carlo experiment follows that of
Stambaugh (1981), with two major exceptions. First, we use more replications:
generally 4000, though only 2000 for the more expensive parametric configura-
tions (when K 2 15, or when T 2 200). Second, because we consider tests of
both the BJS restrictions (3) and the FM restrictions (2), and since (3) implies
(2), we choose the parameters so that (3) is satisfied.
We performed a total of sixteen experiments. Each experiment requires the
specification of the following parameters: T, K, pm, a,, yl, fl, 2. We then create
a set of T realizations for r,,,, as T independent drawings from N(p,,ui),
using a pseudo-random number generator. We calculate a! according to (2),
where except in one case y; = - y1 so that (3) holds as well. We then calculate
T values of E(r,)=a,+&,,,, i=l,..., K. These calculations are only done
once per experiment. Then, for each of the 4000 (or 2000) replications, we do
the following. We generate ( E,~, E,~, . . . , E,~), t = 1,. _. , T, as independent draw-
ings from N(0, Z), using the random number generator. Adding E, to E( r,), we
calculate the T realizations of ri for i = 1,. . . , K. Using the data on the
individual returns (ri) and the market return (r,,,), we calculate the test
statistics given in the last section. Finally, cumulating the results of the 4000
(or 2000) replications, we calculate the mean and variance of each test statistic;
the number of rejections of the null hypothesis [either (2) or (3)] at the l%, 5%
and 10% level; and the x2 goodness of fit statistic (based on ten equiprobable
cells) which tests whether the actual distribution of the test statistic under the
null hypothesis conforms to its hypothetized distribution (either x2 or F).
Most of our experiments use T = 72, but we test the effect of changing T by
also considering T = 30, 200 and 400. Similarly, most of our experiments use
K = 5, but we test the effect of changing K by also considering K = 10, 15, 20
and 30. All of our experiments use a,,, = 0.0328 (Stambaughs value). All use
y1 = 0.0012 (Stambaughs value) except for one experiment which uses y1 =
0.006. We vary p and .Z widely. Specific parametric configurations will be
given in the next section.

4. Results of the experiment

The main results of our experiments are given in tables 2-5. (Table 1 lists
some of the parameter values used in the experiments, to which we will refer
shortly.) These results are for the tests based on the Newton-Raphson esti-
mates. We have not reported separately the results for the tests based on the
actual MLEs, because they are so similar to the results in tables 2-5.
For each test statistic, and for each experiment, we report the proportion of
rejections of the null hypothesis (that the restrictions are correct) at the l%, 5%
and 10% levels, the x2 goodness of fit statistic, and the mean and variance of
 Table 1
Values of /!I (betas of individual assets) and 1 (error covariance matrix) used in experiments.

& = (0.507.0.881, 1.015, 1.296, 1.427)

& = (0.507, 0.573, 0.672,0.881,0.905, 1.015, 1.111, 1.176, 1.296T1.427)
& = (0.507, 0.573,0.609,0.672,0.867,0.881, 0.905, 0.995. 1.015. 1.060, 1.111, 1.133, 1.176, 1.296, 1.427) ys
& = (0.507,0.573,0.672.0.881,0.905, 1.015, 1.111, 1.176, 1.296, 1.427, -0.102, -0.044.0.015.0.035,0.092) P
& = (0.7661,0.9531, 1.0201, 1.1606.1.2261) h
1
& = (0.707, 1.081.1.215, 1.496, 1.627) L
3
0.26 2
0.12 0.32 4
3
0.09 0.24 0.45
0.26 0.08 0.17 0.18 0.23 2
x, = 0.08 0.23 2, = 0.06 0.24 0.24 0.19 0.40 E
0.09 0.20 0.58 0.09 0.25 0.29 0.20 0.33 0.58 .g
-0.04 0.17 0.41 0.94 -0.01 0.15 0.18 0.13 0.22 0.30 0.36 %
-0.10 0.10 0.31 0.40 0.58 0.01 0.07 0.15 0.08 0.08 0.00 0.08 0.40 %
-0.04 0.25 0.31 0.17 0.34 0.41 0.31 0.10 0.94 C
-0.10 0.13 0.16 0.10 0.25 0.31 0.31 0.05 0.40 0.58 $
0.26 0
0.12 0.32
0.08 0.23 0.34
0.09 0.24 0.27 0.45
0.15 0.40 0.42 0.54 1.08 a
0.08 0.17 0.13 0.18 0.27 0.23 :!
H, = 0.06 0.24 0.22 0.24 0.40 0.19 0.40
0.05 0.28 0.24 0.31 0.59 0.18 0.33 0.97 s
0.09 0.25 0.22 0.29 0.58 0.20 0.33 0.46 0.58 z
0.14 0.17 0.08 0.11 0.41 $
0.00 0.08 0.06 0.13 0.22
-0.01 0.15 0.11 0.18 0.36 0.13 0.22 0.39 0.30 0.13 0.36
-0.05 0.04 0.00 0.00 0.04 0.12 0.06 0.09 0.08 -0.12 0.17 0.59
0.01 0.07 0.09 0.15 0.14 0.08 0.08 0.10 0.00 0.15 0.08 -0.05 0.40
-0.04 0.25 0.26 0.31 0.58 0.17 0.34 0.60 0.41 0.16 0.31 0.11 0.10 0.94
-0.10 0.13 0.09 0.16 0.31 0.10 0.25 0.41 0.31 0.12 0.31 0.14 0.05 0.40 0.56

- _.- - _ -_ -. - - - . ._ - _ .~ ._ - - - _. - - - .
 Table 1 (continued)

fil - (0.507,0.881,1.015,1.2%, 1.427)

& = (0.507,0.573,0.672,0.881,0.905,1.015,1.111,1.176,1.296,1.427)
8, = (0.507,0.573,0.609,0.672,0.867,0.881,0.905,0.995,1.015,1.060, 1.111, 1.133, 1.176, 1.296, 1.427)
8, =(0.507,0.573,0.672,0.881,0.905,1.015,1.111,1.176,1.296,1.427, -0.102, -0.044,0.015,0.035,0.092)
& = (0.7661,0.9531,1.0201,1.1606,1.2261)
/I&- (0.707,1.081,1.215,1.4%, 1.627)

0.26
0.12 0.32
0.09 0.24 0.45
0.08 0.17 0.18 0.23
0.06 0.24 0.24 0.19 0.40
0.09 0.25 0.29 0.20 0.33 0.58
-0.01 0.15 0.18 0.13 0.22 0.30 0.36
H, = 0.01 0.07 0.15 0.08 0.08 0.00 0.08 0.40
-0.04 0.25 0.31 0.17 0.34 0.41 0.31 0.10 0.94
-0.10 0.13 0.16 0.10 0.25 0.31 0.31 0.05 0.40 0.56
0.10 0.00 0.00 0.05 -0.03 - 0.02 -0.06 0.09 - 0.06 -0.13 0.23
0.12 0.02 0.02 0.04 - 0.02 -0.02 - 0.07 0.07 - 0.06 -0.12 0.17 0.20
0.20 0.07 0.06 0.05 0.04 0.00 - 0.01 0.08 - 0.02 -0.11 0.18 0.20 0.67
0.18 0.07 0.04 0.02 -0.01 - 0.02 - 0.04 0.09 -0.08 -0.18 0.18 0.20 0.28 0.60
0.17 0.10 0.09 0.10 0.14 0.11 0.02 0.13 0.12 -0.01 0.17 0.20 0.21 0.20 0.55
 Table 2
Proportions of rejections, x2 goodness of fit statistics, means and variances, for various tests based on two-step estimators.=

Tests of FM model ( K 2 restrictions) Tests of BJS model (K 1 restnctmna)

Exp. no. w LR LM Q Q ~- CSR LR* W LR LM Q P-or CSR LR
___~ _~~. ~~~ ~
1 1% 0.007 0.014 o.wx 0.016 0.01 x 0.010 0010 0.040 0 042 0 028 0 055 0.061 0.034 0 034
5% 0.046 0.061 0049 0.068 0 075 0.050 004x 0.!33 0 140 0 112 0 159 0169 0.119 0.117
T= 72 10% 0.100 0.119 0.107 0 123 0.132 0.104 0 103 0.225 0.234 0 207 0.246 0 261 0.204 0.207
z ** ** ** l * ff
K=5
M:an 14.7
3.03 4X.1
3.18 19.3
3.07 35.0
3.21 h2.4
3.30 26
1.04
9 2
7.0x
9x 5**
50 5**
60 5 30 5 76 5 92 1.38 5.29
Var. 5.52 6.63 5.76 7.25 7 67 0.76 5 x3 13.0 139 112 16.4 17 3 0 94 12.4

2 1% 0.007 0.014 0.008 0016 0.01x 0.010 0.010 0.014 0.015 0.009 0021 0.025 0.010 0010
5% 0.046 0.061 0049 0 06X 0 075 0050 0.04X 0.062 0.066 0.052 0 074 0.080 0.056 0.054
T= 72 10% O.lGil 0.119 0.107 0.123 0 132 0.104 0.103 0.11x 0 126 0 103 0.136 0.146 0.102 0.103
K=5 14.7 4X.1 19.3 35 0 62.4 26.9 7.08 32 X 4x 1 19 3 6X.7 ** 26.9 5 12
I& 3.03 3.1x 3.07 3.21 3.30 1.04 2.9X 4.25 4 31 4 13 4 39 4.52 1.05 407
Var. 5.52 6.63 5.76 7.25 7 67 0 76 5.83 X.69 9 16 7.71 104 11.0 0.59 8.17
~___ ~~.
3 1% 0.000 0.019 0.006 0035 0.039 0.011 0.010 0018 0 022 0.006 0.040 0.046 0.010 0.010
5% 0.000 0.076 0.042 0.103 0.113 004X 0046 0.06X 0 079 0041 0 117 0129 0.051 0.051
T= 72 10% 0.001 0.140 0.095 0.171 0.1X6 0099 0094 0.133 0.147 0.091 0.18X 0202 0 loo 0.100
K= 10 2 l * l t 39.8 ** ** 10.9 115 ** ** 42.6 l* ** 6.95 8.64
h!& 2.51 8.72 8.09 9.15 9.42 1.03 7.87 9.71 9.90 9.12 10.5 10.8 1.03 9.00
VU. 3.84 19.2 14.3 24.9 26.3 0.32 15.7 20.5 22 1 15.X 29 6 31.3 0.29 1X 3

4 1% O.ooO 0.02X 0.003 0.074 0.085 0009 0009 0.022 0 030 0002 0 OPR 0.097 0.009 0.010
5% 0.000 0 112 0.035 0.1x2 0 205 0050 0.047 0.090 0 112 0.030 0.200 0218 0050 0.053
T= 72 10% O.COO 0.193 0.092 0 269 0 2X8 010x 0103 0 171 0.197 0.0x9 0.291 0312 0105 0.105
K= 15 x2 ** * l 30.0 ** ** 7 72 X.06 ** ** 41.6 l * *l 3.94 3.63
MeatI 2.91 14.9 13.2 16.3 16.X 1.04 12.9 15 7 16 1 14.3 179 1x.4 104 14.1
Var. 5.09 34.1 21.5 52.1 55.1 021 25.1 33.0 36 7 22.4 5x 0 61.4 0.20 2x.1

5 1% 0.000 0.028 o.tnl2 0.076 0 085 0.006 0.006 0.020 0 029 0.003 0.086 0,098 0.008 0.00X
5% O.ooO 0.106 0.035 0.184 0.198 0.050 0.047 0.096 0.117 0 032 0.196 0.217 0.04X 0.049
T=l2 10% 0.001 0.190 0.089 0.271 0.293 0.102 0.095 0.172 0 194 0 OXX 0.284 0.316 0.104 0.104
K= 15 2 ,I t. 54.1 l * ** 4.48 2.70 ** ** 46.4 l * *l 6.14 4.58
M&n 2.99 14.9 13.3 16.4 16.9 105 12.9 15.X 16.2 14.3 179 184 1.04 14 1
Var. 5.21 32.5 20.6 49.5 52.3 0.20 24 5 33.5 36.2 22.1 57.3 60.6 0.19 27.7

T is the time-series sample size. K is the cross-sectional sample sue (number of assets). FM and BJS refer to the Fama-MacBeth and
Black-Jensen-Scholes models. W is the Wald test. LR is the likelihood ratio test LR* IS LR with Barletts correction. LM is the Lagrange multipher
test.Q is Shankens adJusted Q statistic. Q is QA without a degree of freedom correction. CSR 15 QA multiplied by a correcfxxa factor reflecting
use of Hotellings T*. ** refers to x2 > 100
36X C. E. Anwler and P. Schmidt, Monte Carlo analysis of CA PM tests

the test statistic. [A double asterisk (**) indicates a x2 value in excess of 100.1
The proportions of rejections differ from the expected proportions
(0.01,0.05,0.10) by an amount which is significant at the 5% level if they do
not fall in the intervals [0.007,0.013], [0.044,0.056], and [0.091,0.109], respec-
tively. (For experiments 4,. 5, 7, 8, 11, 12 and 13, which used only 2000
replications, the intervals become [0.006, 0.0141, [0.041, 0.0591 and
[0.087,0.113].) Similarly, a x2 statistic exceeding 16.9 indicates a lack of fit to
the hypothesized null distribution which is significant at the 5% level.
Table 2 reports the results of our first five experiments. Roughly speaking,
these are an attempt to replicate the results of Stambaugh (1981). Experiment 1
uses exactly the parameters of Stambaughs case 1: T = 72, K = 5, CL,,,= 0.0125,
en! = 0.0328, yi = 0.0012, yz = 0.0130, /3= /?i of table 1, 2 = Z, of table 1.
Since y2 - CL,,,# yi, however, the null hypothesis (3) specified by the BJS model
is not true for this experiment. (This explains the large number of rejections
reported in table 2 for experiment 1, for tests of the BJS model.) In experiment
2 (and thereafter) we fix this problem by leaving all parameters unchanged
except now CL, = 0.0142. Thus both (2) and (3) - the null hypotheses specified
by the FM and BJS models respectively - will hold, and we investigate the
behavior of the tests under their null hypotheses. (Comparing the tests of the
FM model in experiments 1 and 2 shows that our change in pm does not affect
the results, anyway.)
Similarly, our experiments 3, 4 and 5 are exactly the same as Stambaughs
experiments 2, 3 and 4, except for the above change in CL,,,.For experiment 3
we have K = 10, /3 = p2 of table 1, 2 = Z, of table 1. For experiment 4 we
have K = 15, /3 = & of table 1, Z = Zs of table 1, whereas for experiment 5 we
have K = 15, p = & of table 1, B = I4 of table 1. All other parameters are as
in experiment 2. Stambaughs parameter values basically represent historical
values in his data, as reported in Stambaugh (1981, p. 145).
Our results in table 2 are very similar to those of Stambaugh (1981, table 37,
pp. 155-156). The LM test appears to be more accurate than the W or LR test.
The W test rejects too seldom for tests of the FM model (basically never for
experiments 3,4 and 5) and too often for tests of the BJS model, while the LR
test rejects too often in both cases. The LM test appears to reject too seldom,
in most cases, but it generally does better than the W and LR tests.
The Q, Q* and CSR tests of Shanken were not part of Stambaughs
experiment, nor was Jobson and Korkies LR* test. The QA and Q* tests
perform poorly; they reject far too often. However, the CSR test and the LR*
test are very accurate, generating proportions of rejections close to the desired
levels and (generally) acceptably low x2 goodness of fit values. There is not
much reason to prefer the CSR test to the LR* test or vice-versa.
In table 3, we report the results of some more experiments designed to see
how fast the tests performances improve when T increases. The parameter
values here are the same as in experiment 3 (i.e., Stambaughs experiment 2),
 Table 3
Proportions of rejections, x2 goodness of fit statistics, means and variances, for various tests based on two-step estimators.

Tests of FM model (K - 2 restrictions) Tests of BJS model (K - 1 restrictions)

Exp. no. W LR LM QA Q CSR LR* W LR LM QA Q* CSR LR

6 1% 0.000 0.055 0.000 0.133 0.159 0.013 0.012 0.040 0.062 0.000 0.171 0.201 0.013 0.015
5% 0.001 0.156 0.032 0.246 0.283 0.063 0.053 0.133 0.178 0.030 0.291 0.338 0.058 0.063
T= 30 10% 0.010 0.240 0.098 0.331 0.374 0.115 0.104 0.218 0.264 0.089 0.383 0.425 0.118 0.123
2 ** ** ** ** ** 14.1 ** ** ** ** **
K=lO 10.7 18.0 32.7
h&l 2.34 10.3 8.38 12.1 12.9 1.13 7.87 11.1 11.9 9.45 14.4 15.4 1.14 9.29
Var. 4.50 27.7 12.4 59.9 68.8 0.53 16.3 26.6 32.5 13.1 78.9 90.6 0.50 20.0

3 1% 0.000 0.019 0.006 0.035 0.039 0.011 0.010 0.018 0.022 0.006 0.040 0.046 0.010 0.010
5% 0.000 0.076 0.042 0.103 0.113 0.048 0.046 0.068 0.079 0.041 0.117 0.129 0.051 0.051
T= 72 10% 0.001 0.140 0.095 0.171 0.186 0.099 0.094 0.133 0.147 0.091 0.188 0.202 0.100 0.100
K=lO Mx,,2 ** ** ** **

7 1%
5% 0.000

K= 2
M:an ** 1 .Ol 7.95
3.85 15.1
9.24 17.1 12.9 36.5 45.4 14.3 17.1
9.29 9.03 9.46 9.55 1.01 8.98
Var. 3.92 16.4 14.9 17.8 18.1 0.26 15.3 18.2 18.5 16.6 20.3 20.7 0.23 17.3

1%
5% 0.000
0.113 0.109
K= 10 2
h&an II 12.7

aT K is of assets). FM and to the

W is LR is LM
Q Q statistic. Q is a degree of is by a correction factor
of Hotellings ** refers to > 100.

-- - -. - .^ . ._ _ __ _ ,_, ,_, _, _ ,, _ ,_ ,_ ,_
 Table 4
Proportions of rgections, x2 goodness of fit statistics, means and variances. for various tests based on two-step estimators.a

Tests of FM model (K - 2 restrictions) Tests of BJS model (K - 1 restrictions)

Exp. no. W LR LM Q 0 CSR LR W LR LM QA Q* CSR LR

9 1% 0.006 0.015 0.010 0.020 0.021 0.010 0.010 0.013 0.014 0.010 0.020 0.023 0.012 0.012
5% 0.037 0.061 0.048 0.067 0.074 0.049 0.047 0.061 0.067 0.051 0.076 0.085 0.054 0.054
T-72 10% 0.090 0.127 0.111 0.132 0.140 0.107 0.104 0.119 0.125 0.106 0.134 0.143 0.105 0.106
K-5 IAIlz 15.9
2.95 44.4
3.22 17.9
3.11 54.3
3.26 88.2
3.35 13.3
1.06 4.60
3.02 34.1
4.26 46.9
4.31 18.7
4.13 62.8
4.39 4.51
** 31.7
1.05 4.07
8.50

VU. 5.04 6.83 5.92 7.50 7.94 0.79 6.01 8.88 9.31 7.82 10.6 11.2 0.61 8.31

10 1% 0.001 0.019 0.008 0.037 0.042 0.011 0.010 0.016 0.022 0.006 0.040 0.048 0.012 0.012
5% 0.014 0.075 0.044 0.104 0.113 0.049 0.047 0.070 0.082 0043 0.118 0.131 0.053 0.053
T= 72 10% 0.035 0.140 0.095 0.169 0.186 0.100 0.094 0.131 0.148 0.096 0.188 0.203 0.103 0.103
K- 10 2 l .* 30.7 * l* 8.04 9.79 92.3 l* 35.6 ** l* 8.63 6.90
&an 6.99 8.70 8.08 9.14 9.40 1.03 7.85 9.64 9.91 9.13 10.5 10.8 1.03 9.02
VU. 9.53 19.5 14.4 25.2 26.6 0.32 15 9 20.2 22.4 16.1 29.9 31.7 0.29 18.5

11 1% o.cHx 0.025 0.004 0.067 0.080 0.007 0.007 0.014 0.024 0.003 0.080 0.090 0.007 0.007
5% 0.005 0.105 0.032 0.178 0.198 0.045 0.042 0.078 0.113 0.027 0.194 0.215 0.046 0.050
T-72 10% 0.012 0.184 0.087 0.277 0.296 0.101 0.094 0.152 0.190 0.081 0.288 0.320 0.100 0.100
K- 15 2 ** l. 29.8 ** l* 11.4 11.0 ** l* 48.1 l* ** 14.6 8.67
h&an 10.6 14.7 13.1 16.2 16.6 1.03 12.8 15.3 16.0 14.2 17.8 18.3 1.04 14.0
VU. 12.9 32.9 20.9 50.0 52.9 0.20 24.8 30.4 35.7 22.0 56.1 59.3 0.19 27.4

12 1% 0.042 0.002 0.130 0.145 0.007 0.007 0.042 0.003 0.196 0.167 0.002 0.007
5% 0.132 0.025 0.268 0.299 0.047 0.043 0.141 0.025 0.296 0.327 0.045 0.049
T-72 10% 0.225 0.065 0.372 0.412 0.081 0.080 0.236 0.065 0.404 0.437 0.078 0.087
K-20 * *1:; 81.3 ** ** 22.4 16.4 l* 877 l* ** 23.1 12.8
h&l 18.1 24.3 25.0 1.02 17.6 22.5 19.1 26.2 26.9 1.02 18.9
VU. 49.0 26.1 89.7 94.9 0.16 34.0 51.8 26.6 98.8 104.0 0.15 36.6

13 1% 0.126 0.001 0.420 0.453 0.011 0.012 0.146 0.001 0.452 0.487 0.013 0.014
5% 0.295 0.016 0.605 0.634 0.047 0.050 0.316 0.014 0.645 0.670 0.046 0.060
T- 72 107 0.416 0.053 0.692 0.727 0.100 0.107 0.430 0.048 0.722 0.749 0.101 0.126
K-30 l* ** l* It 12.6 5.75 .* t* l* tt 10.4 32.9
h&l 36.8 28.4 47.9 49.2 1.05 28.1 38.5 29.4 50.7 52.2 1.05 29.7
VU. 101.0 34.5 300.0 318.0 0.14 59.1 107.0 35.0 333.0 352.0 0.14 63.7

aWald tests are not available for K = 20 or K = 30, to avoid having to invert matrices of dimension 40 or 60.
T is the time-series sample size. K is the cross-sectional sample size
 Table 5
Proportions of rejections, x2 goodness of fit statistics, means and variances, for various tests based on two-step estimators.

Tests of FM model (K - 2 restrictions) Tests of BJS model (K - 1 restrictions)

Exp. no. W LR LM Q Q* CSR LR W LR LM QA 0* CSR LR*

2 1% 0.007 0.014 0.008 0.016 0.018 0.010 0.101 0.014 0.015 0.009 0.021 0.025 0.010 0.010
5% 0.046 0.061 0.049 0.068 0.075 0.050 0.048 0.062 0.066 0.052 0.074 0.080 0.056 0.054
T=72 10% 0.100 0.119 0.107 0.123 0.132 0.104 0.103 0.118 0.126 0.103 0.136 0.146 0.102 0.103
K=5 2
i&Ul 14.7
3.03 48.1
3.18 19.3
3.07 35.0
3.21 62.4
3.30 26.9
1.04 7.08 32.8 48.1 19.3 68.7 ** 26.9 5.12
2.98 4.25 4.31 4.13 4.39 4.52 1.05 4.07
Var. 5.52 6.63 5.76 7.25 7.67 0.76 5.83 8.69 9.16 7.71 10.4 11.0 0.59 8.17

14 1% 0.001 0.013 0.009 0.016 0.018 0.010 0.010 0.001 0.016 0.008 0.020 0.022 0.012 0.012
5% 0.008 0.063 0.048 0.067 0.074 0.049 0.047 0.017 0.067 0.054 0.074 0.080 0.056 0.054
T=72 10% 0.035 0.115 0.103 0.120 0.131 0.102 0.099 0.051 0.124 0.105 0.133 0.145 0.104 0.105
K=5 x2 *a 18.9 8.22 25.1 51.1 3.56 6.65 ** 38.9 13.0 58.6 ** 32.1 4.88
Mean 2.43 3.14 3.03 3.17 3.26 1.03 2.94 3.57 4.29 4.10 4.36 4.49 1.04 4.05
Var. 2.93 6.72 5.83 7.36 7.79 0.77 5.90 4.91 9.33 7.82 10.6 11.2 0.61 8.32

15 1% 0.007 0.014 0.008 il.016 0.018 0.010 0.010 OX06 0.014 0.009 0.019 0.022 0.012 0.012
5% 0.046 0.062 0.049 0.068 0.075 0.050 0.048 0.037 0.064 0.048 0.073 0.083 0.050 0.049
T=72 10% 0.100 0.119 0.106 0.122 0.132 0.104 0.103 0.086 0.126 0.106 0.136 0.145 0.104 0.106
K=5 h&l2 14.7
3.03 32.6
3.18 19.9
3.07 35.0
3.21 62.4
3.30 3.15
1.04 7.08
2.98 24.5
3.94 50.5
4.31 21.7
4.12 67.8 ** 46.8 8.20
4.38 4.51 1.05 4.07
Var. 5.52 6.63 5.76 7.25 7.66 0.76 5.83 6.80 9.39 7.86 10.7 11.3 0.61 8.40

16 1% 0.006 0.012 0.008 0.014 0.018 0.009 0.008 0.012 0.014 0.007 0.020 0.022 0.009 0.009
5% 0.045 0.062 0.049 0.068 0.073 0.050 0.047 0.059 0.062 0.052 0.070 0.078 0.053 0.053
T= 72 10% 0.096 0.112 0.101 0.118 0.129 0.099 0.092 0.121 0.128 0.105 0.133 0.142 0.103 0.105
K=5 h&l2 8.93
3.01 18.6
3.17 10.0
3.06 19.9
3.20 45.8
3.29 11.3
1.04 3.98
2.97 37.5
4.24 55.2
4.30 20.7
4.12 64.8
4.38 ** 29.5 5.47
4.50 1.05 4.06
Var. 5.42 6.56 5.70 7.16 7.58 0.75 5.76 8.55 9.05 7.62 10.3 10.8 0.59 8.07

aT is the time-series sample size. K is the cross-sectional sample size (number of assets). FM and BJS refer to the Fama-MacBeth and
Black-Jensen-Scholes models. W is the Wald test. LR is the likelihood ratio test. LR* is LR with Barletts correction. LM is the Lagrange multiplier
test. Q is Shankens adjusted Q statistic. Q is Q without a degree of freedom correction. CSR is Q multiplied by a correction factor reflecting
use of Hotellings T*. ** refers to x2 > 100.
312 C. E. Amsler and P. Schmidt, Monte Carlo atzalysis of CA PM !esfs

except for experiments 6, 7 and 8 we have T = 30, 200 and 400, respectively.
The results generally support our expectation that the tests should become
more accurate as T increases (since all of the tests are valid asymptotically).
The LR, LM, LR* and CSR tests are at all reasonably accurate by T = 200.
For T = 30, only the CSR and LR* tests are at all reliable. The Wald test of
the FM model continues to do very poorly (almost no rejections) even for
T=400.
In table 4 we report the results of five experiments designed to test the effect
of changing K (the number of assets). Experiment 9 has K = 5 and is identical
to experiment 2 except that now 2 is a diagonal matrix with diagonal elements
equal to 0.0003. (Incidentially, comparing experiments 2 and 9 shows that this
change makes very little difference.) A diagonal matrix is convenient in this
context because we can change its size (from 5 to 30) without changing its
character. Experiment 10 has K= 10, and p is the same as for experiment 9
but with each element of p repeated twice. Similarly for experiments 11, 12
and 13, with K= 15, 20 and 30, respectively, we repeat each element of p
three, four, or six times. Thus we attempt to change K without changing the
nature of X and /3.
The results support our expectation (based on the results for table 1) that the
tests should perform less well when K increases, for T fixed. This clearly
happens, except for the CSR and LR* tests, which continue to perform
reasonably well even for K = 30.
Finally, in table 5 we report the result of three more experiments which test
the effects of changes in other parameters. These experiments are variations of
our experiment 2 (Stambaughs experiment 1) and hence have T = 72 and
K = 5. In experiment 14 we shrink the range of /3 by moving each element of p
halfway to the mean value; explicitly, /I = & of table 1. In experiment 15 we
use the same /3 as in experiment 2, but with 0.2 added to each element. (Thus
in these two experiments we have changed the variance and the mean of the
ps, respectively.) In experiment 16 we revert to the /3 of experiment 2, but use
yi = 0.006 (and y2 = 0.0082 so yZ - p, = - yi). None of these changes makes
any real difference, except for the Wald test.
As mentioned above, the results for the tests based on the actual MLEs are
very similar to the results for the tests based on the Newton-Raphson
estimates. The proportions of rejections typically differ by only 0.001 or 0.002,
and such small differences are not worth a separate discussion. However, the
fact that the choice of estimator makes so little difference is itself interesting. It
confirms the existing feeling that CAPM tests based on the Newton-Raphson
estimates are as reliable as tests based on the MLEs.

5. Some results on estimation

Although the point of the paper is the accuracy of CAPM tests, not the
properties of parameter estimates, we did calculate summary statistics for
 C. E. Amsler and P. Schmidt, Monte Carlo analysis of CA PM tests 373

various estimates of y1 and yz, as a byproduct of the experiment. We

considered three estimators. The first is OLS 2PASS, defined as in (4) and (8)
but with 2 = I; it is the usual (old-fashioned) two-pass estimator. The second
is LINMLE, defined as in (4) and (8) which is the Newton-Raphson
estimator. The third is MLE, which is indeed the MLE. All three are
consistent as T --, co. Only MLE is consistent as K - 00 [and if 2 is fixed as
a non-singular matrix; see Shanken (1982)]. The last two estimators are
asymptotically efficient.
Although the calculations were done for each of our sixteen experiments, to
save space we report results only for experiments l-5. In table 6 we display the
mean, variance, mean square error (MSE) and average absolute error (AAE) of

Table 6
Means, variances, mean squared errors and average absolute errors, for various estimators;
estimates of y, (FM model) and y (BJS model).

FM model BJS model

Variance OLS Variance OLS
Exp. no. bound ZPASS LINMLE MLE bound 2PASS LINMLE MLE

1 Mean x lo- 0.1263 0.1508 0.0989 -0.0492 0.2047 0.3448

T= 72 var x 1o-4 0.1511 0.1605 0.1559 0.5176 0.1461 0.2157 0.1543 99.12
K=5 MSE x 1O-4 0.1605 0.1569 0.5181 0.2444 0.1615 99.17
AAE x lo-* 0.3177 0.3139 0.3322 0.3876 0.3210 0.5675

2 Mean x lo-* 0.1263 0.1508 0.0989 0.1551 0.1610 0.0736

T= 12 Varx 1O-4 0.1511 0.1605 0.1559 0.5176 0.1467 0.2206 0.1548 0.2089
K=5 MSE x 1O-4 0.1605 0.1569 0.5181 0.2218 0.1565 0.2110
AAE x lo-* 0.3177 0.3139 &3322 0.3715 0.3147 0.3349

3 Mean x lo- 0.1322 0.1605 0.1092 0.1619 0.1699 0.0910

T=72 Var X 1O-4 0.0844 0.1029 0.0950 0.1027 0.0779 0.1054 0.0904 0.1073
K= 10 MSE x 1O-4 0.1030 0.0966 0.1028 0.1072 0.0929 0.1082
AAE x lo-* 0.2570 0.2488 0.2557 0.2609 0.2431 0.2499

4 Mean x lo-* 0.1665 0.1817 0.1116 0.2014 0.1885 0.0948

T=72 Var x 10m4 0.0666 0.1125 0.0789 0.0879 0.0648 0.1119 0.0788 0.0923
K= 15 MSE x 1O-4 0.1147 0.0827 0.0880 0.1185 0.0835 0.0929
AAEx lo-* 0.2701 0.2314 0.2376 0.2740 0.2324 0.2369

5 MeanxlO-* 0.1195 0.1304 0.1210 0.1247 0.1361 0.1174

T= 72 var x 10-4 0.0142 0.0366 0.0166 0.0168 0.0117 0.0365 0.0145 0.0139
K= 15 MSE x 1O-4 0.0366 0.0168 0.0168 0.0365 0.0147 0.0139
AAE x lo-* 0.1521 0.1040 0.1041 0.1521 0.0969 0.0934

T is the time-series sample size. K is the cross-sectional sample size (number of assets). FM
and BJS refer to the Fama-MacBeth and Black-Jensen-Scholes models. y, and y are parameters
of these models (risk premia). OLS ZPASS is the two-stage cross-sectional regression estimator.
LINMLE is the linearized maximum likelihood estimator (Newton-Raphson estimator). MLE is
the maximum likelihood estimator. Variance bound is the asymptotic variance from the informa-
tion matrix. MSE and AAE are abbreviations of mean squared error and average absolute error.
374 C. E. Amler and P. Schmidt, Monte Carlo analysis of CA PM tests

each estimator. We also display the variance bound, which is the asymptotic
variance from the information matrix. The true value of y1 (FM model) or y
(BJS model) is 0.0012 in each of these five experiments, so asymptotically
mean x 10e2 should equal 0.1200.
Although we will not discuss these results in detail, some general conclusions
are clear. First, the Newton-Raphson estimator generally outperforms the
OLS two-pass estimator in terms of variance, MSE and AAE, but not in terms
of bias. Second, the Newton-Raphson estimator generally outperforms the
MLE. The MLE is generally biased downward, while the Newton-Raphson
estimator is generally biased upward. The MLE always has a higher variance
than the Newton-Raphson estimator. The MLE occasionally was off by
spectacularly large amounts, due to a few outliers, though this did not occur in
any of the experiments reported in table 6. The only potential reason to prefer
the MLE is on the basis of smaller bias when K is large relative to T.
Otherwise the Newton-Raphson estimator is generally the preferred one.

6. Conclusions
The main results of our experiment are clear and easily summarized:

1. The Wald test is unreliable.

2. Shankens QA and Q* tests are unreliable.
3. The LR test is better than the tests in 1 and 2, but it is still unreliable unless
the sample size is very large. Its problem is that it rejects the null hypothesis
too often (when it is true).
4. The LM test is considerably better than the tests in 1, 2 and 3. It is
reasonably reliable except when T is small or K is relatively large, in which
case it exhibits a tendency to reject the null hypothesis too seldom.
5. Shankens CSR test and Jobson and Korkies LR* test are quite reliable
under all circumstances which we consider.
6. There is no basis in our results to prefer the CSR test to the LR* test, or
vice versa.

These conclusions have obvious important implications for empirical tests of

CAPM. It is therefore important to emphasize the usual disclaimer concerning
Monte Carlo results - the results may not hold for parameter values other than
those considered. We have tried to consider a reasonably broad set of parame-
ter values. In particular, our range of K and T is considerably wider than in
previous experiments, and includes values similar to those used in previous
empirical CAPM tests. Nevertheless, there is no guarantee that the results may
not be different at other parameter points. Only by deriving tests with known
finite sample distributions can this difficulty be avoided.
 C. E. Amsler und P. Schmidt. Monte Curlo un&su of CA PM tests 375

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