Explaining the Cross-Section of Returns via a Multi-Factor APT Model

Author(s): Jianping Mei

Source: The Journal of Financial and Quantitative Analysis, Vol. 28, No. 3 (Sep., 1993), pp.
331-345
Published by: Cambridge University Press on behalf of the University of Washington School of Business
Administration
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 ANDQUANTITATIVE
OF FINANCIAL
JOURNAL ANALYSIS VOL.28, NO 3, SEPTEMBER
1993

Explaining the Cross-Section of Returns via a

Multi-Factor APT Model

Jianping Mei*

Abstract

This paper uses an autoregressive approach to test a multi-factor model with time-varying
risk premiums. A quasi-differencing approach is used to eliminate the unobservable factors
in the model. It is found that the model is capable of capturing the "size effect" and the
"dividend yield effect," but is incapable of explaining the "book-to-market effect" and the
"earnings-price ratio effect." Thus, it is concluded that a constant-beta multi-factor model
will not be able to explain the cross-sectional variation in expected returns.

I. Introduction

Recent studies by Fama and French (1992) and Jegadeesh (1992) provide
some quite damaging evidence against the validity of the Capital Asset Pricing
Model (CAPM). They show that the market beta has little power in explaining the
cross-sectional variation in asset returns, while "two easily measured variables,
size and book-to-market equity, provide a simple and powerful characterization of
the cross-section of average stock returns..." (Fama and French (1992), p. 429).
Their discovery, plus earlier evidence against the CAPM,l raises serious ques?
tions about the central prediction of modern finance, which asserts that systematic
risks are the fundamental determinant of asset returns. One possible explanation
for the failure of the market beta to explain the cross-section of average returns is
that stock risks are multi-dimensional instead of one-dimensional as described by
the CAPM. Thus, the question becomes, can a multi-factor asset pricing model,
such as the arbitrage pricing theory (APT) of Ross (1976), offer a comprehensive
explanation of the cross-section of average returns? That is, can the multiple be?
tas from a multi-factor model absorb the role of size and book-to-market equity

*Departmentof Finance, Stern School of Business, New YorkUniversity,New York,NY 10003.

The paper has benefited greatly from comments by JFQA Managing Editor Paul Malatestaand an
anonymousJFQA referee. The authoris gratefulto GordonBodnar,StephenBrown, JohnCampbell,
GregoryChow, Angus Deaton, Edwin Elton, Wayne Ferson, Bill Gentry,Lars Hansen, LarryLang,
Albert Margolis, Whitney Newey, Harvey Rosen, and Ken Singleton for helpful comments and dis-
cussions. Douglas Holtz-Eakingraciouslyprovidedthe programfor panel regression. The authoralso
appreciatesfinancialsupportfrom the John M. Olin Foundationfor Study of Economic Organization
and Public Policy.
^ee, for instance, Banz (1981), Basu (1983), Bhandari(1988), Chan, Hamao, and Lakonishok
(1991).
331

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332 Journal of Financial and Quantitative Analysis

so that asset returns are still determined ultimately by systematic risks instead of
firm-specific variables?
To address these questions, this paper uses a simple autoregression approach
to study the ability of a multi-factor model in explaining average returns. It is
found that a multi-factor model with constant betas is capable of absorbing the
role of size and dividend yield but is incapable of overtaking the role of book-to-
market (B/M hereafter) ratio and earnings-price (E/P hereafter) ratio in explaining
expected returns.
This paper's approach has several distinct advantages over many previous
studies on the multi-factor APT model.2 First, by using a linear combination of
historical returns to proxy for the unobservable betas, the method used neither
needs to estimate betas for a large cross-section of stocks, nor does it need factor
estimates. As a result, there are many fewer parameters to estimate and the degrees
of freedom in the study are thus increased. Second, the autoregression approach
allows for time-varying risk premiums, which take into account the fact that asset
expected returns vary over time due to changing business conditions and changing
risk perceptions.3 In addition, this paper studies firm-specific effects (e.g., the
B/M ratio), which are found to be important in explaining asset returns but have
received relatively little attention in previous APT studies. However, this study
does have a caveat of restricting assets to have constant betas, at least over a period
of time equal to the number of factors.
The paper is organized as follows. Section II presents a simple autoregressive
approach to the study ofthe APT model. Section III describes the data and studies
the relationship between annual returns and firm-specific variables. Section IV
presents the autoregression results. Section V concludes.

II. An Autoregression Approach to the Multi-Factor APT

Model

First, the main idea of this paper is illustrated, using a one-factor model.
Assume that capital markets are perfectly competitive and frictionless. Investors
believe that asset returns are generated by the following one-factor model,

(1) Rit = Et-X(Rit)+ft(3i + eit i=\,...,N, t=\,...,T,

where Et- \ (Rit) is the expected return on asset / conditional on information set It- \
known at the end of period t ? 1; f is a scalar of an unobservable random factor
with time-varying distribution; #? is the factor loading, which is constant during
the sample period; and eit represents an idiosyncratic risk specific to asset /. It is
also assumed that Et_x(ft) = 0, E(et\ft) = 0, and Cov,_i(e,) = Dt, where Dt is a

diagonal matrix.
Using the equilibrium APT of Connor and Korajczyk (1988), the above econ?
omy implies the following linear pricing relationship,

(2) Et_x(Rit) = A0, + A,A,

2Most recent studies include Connor and Korajczyk(1988), Lehmannand Modest (1988), and
Shuklaand Trzcinka(1990).
3See Campbell(1987), KeimandStambaugh(1986), andFersonandHarvey(1991), amongothers,
for the literatureon time-varyingrisk premiums.

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 Mei 333

where Xt is a time-varying risk premium corresponding to the risk factor, and Ao,
is the return on a riskless (or "zero beta") asset.
Combining (1) and (2) and denoting st =f + Xt obtains

(3) Rit = X0t + stPi + eit, i=l,...,N; t=\,...,T.

It is easy to see from Equation (3) that the cross-sectional variation in expected
returns is determined by the factor loading #. If one were able to observe /?/, one
would be able to test Equation (3) through a cross-sectional regression and to see
if fy alone could explain the cross-sectional variation in expected returns. Since
(3l is not observable, it needs to be replaced by some other observable variables.
To get rid of the unobservable /?/ in Equation (3), the pseudo-differencing
approach of Holtz-Eakin, Newey, and Rosen (1988) is employed. Equation (3) is
taken for time period f ? 1 and both sides of the equation are multiplied by st/st- \
and subtracted from Equation (3) for time period f, and terms are collected. This
results in4

(4) Rit = <ip0t+ ipuRi,t-\ + 77,7, i=l,...,N; t = 2,...,T,

where

(5)^0, = Ao,-A0,/-i; ipu = -; Vit = ?n-?,,/-i;

st-\ St-\ St-\

and where ij)Qtand ij)\t are constant across firms.

Therefore, the one-factor model of (3) is transformed into a one-lag autore?
gressive model. The intuition behind (4) is that lagged returns are useful in ex?
plaining the cross-section of current returns because they span the same return
space as f3l and, thus, can be used as proxies for systematic risks. The substitution
of unobservable betas by lagged returns is similar in spirit to the technique of
substituting unobservable factors by the "mimicking factor portfolio" returns used
by Jobson (1982), Burmister and McElroy (1988), and Huberman, Kandel, and
Stambaugh (1987).
It is worth noting here that although there always exists an ex post efficient
benchmark portfolio by which ex post betas can be defined and the linear rela?
tionship (2) will hold, that "benchmark portfolio" will not necessarily be on the
ex ante efficient portfolio frontier. In other words, the ex post betas may not be
written as a linear function of the true betas. Thus, the regression of asset returns
on the ex post betas (or on lagged returns) will generally not give error terms in
Equation (3) that are uncorrelated and unpredictable by other variables, which can
be detected by some tests shown later. So, the tests here are joint tests of the linear
pricing relationship (2) and the linear factor model of (1). Either a violation of
the linear pricing relationship or a misspecification of the linear factor model will
cause a statistical rejection.

4Jegadeesh(1990) uses the autoregressiveapproachto study the serialcorrelationin stock returns,

but he does not test the APT model. Mei (1992) uses a similar frameworkto estimate factors from
a semiautoregression,but he does not use the autoregressionapproachto examine the firm-specific
effects.

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334 Journal of Financial and Quantitative Analysis

More generally, for a /f-factor model, one can derive a system of autoregres-
sions similar to Equation (4) by repeatedly applying the above pseudo-differencing
approach to obtain5
K
(6) Rit = ^o/ + 5^^i^iV-; + ^?> i = l,...,#; t = K+l,...,T,

where

- t = K+l,...,T,
(7) ^o ^o? ^2 il>jt*ott-j, Va = eit Y^ ^jtZu-j,
7=1 7=1

where ipjt(J > 0) is a function of current and past sts (see Appendix). Equation
(6) implies that if the returns are generated by a /^-factor APT model, then lagged
returns from t - 1 to t ? K should be sufficient in explaining the cross-sectional
variation in returns at time t via a K-\ag autoregression. In testing the APT against
a specific alternative, this paper follows Fama and French (1992) by including
firm-specific variables in the autoregression of (6). If the linear asset pricing
relationship holds and betas could explain the cross-section of expected returns,
one should have H0 : nt = 0 in the following regression,

(8) Rit = ^0f + ^^'V-7 + 7rAr-i+%. /=1,...,N; t = K+l,...,T,

7=1

where Q,_i represents a firm-specific variable such as the firm's B/M ratio, div?
idend yield, log capitalization (size), or E/P ratio. The rejection of nt = 0 would
indicate the existence of asset pricing anomalies.
In order to perform the above tests, one needs to estimate autoregression (8).
Equation (8) is rewritten as

Ru

(9)
Rm

Equation (9) is stacked by time to make a system of equations. There will

be T - (K + 1) equations in the system. It is worth noting here that individual
asset returns are used to estimate the parameters of each equation. Due to the large
number of cross-sectional observations (more than 800 securities in this study)
and the small number of parameters (less than 10) estimated in each equation, one
could expect fairly accurate estimates of the parameters.
Equation (9) looks very much like the classic seemingly unrelated regressions
(SUR) system. But here the system is a set of cross-sectional regressions for
5See
AppendixI for details.

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 Mei 335

different time periods instead of the conventional set of time-series regressions for
different individuals. The autoregressors Ri,t-j(j = 1,...,K) (and Qr_ i in (8)) are
correlated with the error term rjltthrough their correlation with ?/,_ i,..., ?/,-?, and
there is heteroskedasticity and serial correlation in the error term, rjlt. It follows
from Equation (8) that as long as Su and ipt are independent from each other, the
conditional covariance matrix for r\it will remain diagonal. Thus, Equations (6) and
(8) need to be estimated by an instrumental variables regression and appropriate
adjustments need to be made to take into account the heteroskedasticity and cross-
sectional correlation. Since the Riss (s < t ? K) are orthogonal to r)it and are
correlated with the autoregressors Rt,t-j(j = 1,..., A^)on the right side of (9), they
can be used as instruments for estimating the autoregression.6 The orthogonal
condition is satisfied because the R(s only contains idiosyncratic risk ?js(s < t ? K)
and the rjit only contains idiosyncratic risk elT(r = t ? K,..., t ? 1, f) according
to Equation (7). There is no overlap of idiosyncratic risk in RiS and %, and ?/,
is assumed to be independent over time. Other variables that are known before
time period t ? K and carry information about the asset's risk features, such as the
firm's B/M ratio, price-earnings (P/E hereafter) ratio, size, or dividend yield, also
qualify as potential instruments.
A 3SLS estimation technique, developed by Holtz-Eakin, Newey, and Rosen
(1988), is employed to accomplish the above tasks. The estimates will be consistent
despite the existence of heteroskedasticity and serial correlation.
Intuitively, the estimation procedure is quite similar to that of the 3SLS method
used in the estimation of simultaneous equations. At the first stage, a generalized
instrumental variable regression is used to obtain estimates of (6) for each time
period, ignoring the heteroskedasticity and serial correlation. At the second and
third stages, the residuals from the regression of the first stage are used to calculate
a White-type (1980) variance-covariance matrix, and a generalized least squares
method is used to obtain a more efficient estimate of Equation (6) for all time
periods.
To test restrictions such as 7Tt = 0, a procedure similar to the Chow test is
employed. The strategy is first to estimate the unrestricted (7r, ^ 0) model and
the restricted (nt = 0) model and then calculate the difference in their sum of
squared residuals, Qu and Qr. If the restriction does not hold, then the difference
(L = QR ? Qu) will be large, indicating a rejection of the hypothesis. It is worth
noting here that this procedure can also be used to determine the minimum number
of lags needed to be used in Equation (6).

III. Data Description and the Relationship between Returns

and Firm-Specific Variables

The main data set used is the Compustat Annual Industrial File for 1971?
1990. One advantage of working with this file is that it provides balance sheet
information. Annual data are chosen in order to minimize the problem of non?
synchronous trading and to see whether a multi-factor model with time-varying

6Rls(s < t ? K) are perfect instrumentsfor /?/,/_/(1 < j < K) if the idiosyncraticshocks are
zero. In this case, they are perfectly correlatedbecause they span the same returnspace accordingto
Equation(6).

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336 Journal of Financial and Quantitative Analysis

risk premiums is capable of explaining the long-term cross-sectional variation in

expected returns. To alleviate the problem of survivalship bias, all firms included
in the Compustat tape were used, as long as they have annual returns for 10 years
and have information on firms' B/M ratio, dividend yield, log capitalization, and
P/E ratio for the first two and the last of the 10 years. As a result, the number of
firms in the sample varies over time and, on average, about 880 firms are contained
in the sample at any given time.
Table 1 presents average annual returns based on firm characteristics-sorted
portfolios. For each firm-specific variable, four portfolios of equal size are formed
for positive values and a fifth group is formed for negative (or zero) values, using
all stocks in the sample. The grouping procedure is conducted every year based
on information at the end of the year before the last year. This is to ensure that
the information on which the grouping is performed is publicly available when
the portfolios are formed. The grouping procedure used here is similar to that of
Chan, Hamao, and Lakonishok (1991).

B/M ratio stands for the book-to-market ratio. Size is the log capitalization of the firm. For
each firm-specific variable, four portfolios of equal size are formed for positive values and
a fifth group is formed for negative (or zero) values. The grouping procedure is conducted
every year based on information at the end of the year before the last year.

From Table 1, small stocks earn higher rates of return than large stocks,
showing a difference of 12.5 percent per annum between the two extreme groups.
High B/M stocks outperform low B/M stocks with a difference of 5.5 percent per
annum between the highest and lowest quartiles. High E/P stocks also outperform
low E/P stocks with a difference of 10 percent per annum between the highest and
lowest quartiles. The returns to high dividend yield stocks are the highest for the
second highest quartiles with a difference of 4 percent per annum over that of the
lowest quartile portfolio (also see Figure 1).
Portfolios with negative or zero values of firm-specific variables achieve sig?
nificantly high returns during the time period of 1971-1990. Stocks with negative
or zero B/M, E/P, and DivYld experience a much higher annual rate of returns,
with 82.3 percent for the B/M portfolio, 29 percent for the E/P portfolio, and 25.5
percent for the DivYld portfolio. However, the number of firms in the negative
B/M portfolio is relatively small and the high returns are determined mostly by a
few successful turnaround firms. In summary, what is observed here is that the

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 Mei 337

< or =0 Lcrwest Z 3 Highest

SortedPortfolios
O B/M + E-P Ratio o Size A DivYld
FIGURE 1
Annual Returns on Sorted Portfolios
B/M ratio stands for the book-to-market ratio Size is the log capitalization of the firm. For
each firm-specific variable, four portfolios of equal size are formed for positive values and
a fifth group is formed for negative or zero values. The grouping procedure is conducted
every year based on information at the end of the year before the last year.

firm-specific variables do have significant explanatory power on expected returns.

The challenge to asset pricing theory is: can betas from a multi-factor model ab-
sorb the role of these firm-specific variables and offer a good explanation to the
cross-section of expected returns?

IV. Autoregression Results

A. Estimation of Regression (6) and Test of Minimum Lag Length

Using the data sets constructed from the Compustat Industrial File, the autore-
gressions of (6) are estimated for the time periods of 1981-1990, using previous
years' data from 1972-1980 for lags and instruments. For any given year t, returns
from f ? 1 to f ? K are used as the autoregressors, where K corresponds to the
number of factors in the APT model. Also used are the firm's B/M ratio, dividend
yield, log capitalization, P/E ratio, and returns from time periods f ? 8 to f ? 9 as
instruments to correct for possible correlation between the autoregressors and the
error terms in (6). These variables qualify to serve as instruments because they
are cross-sectionally correlated with the autoregressors but uncorrelated with the
error terms of (6).
Table 2 presents the test results of how many lags should be used in the
autoregressions (6) for the time periods of 1981-1990. The first column of Table
2 specifies the lag length, K, in the autoregression. The second column gives the
generalized sum of squared residuals, Q, corresponding to each specification. The

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338 Journal of Financial and Quantitative Analysis

third column provides the difference in the generalized sum of squared residuals
between its corresponding specification and the specification above it, which has
one more lag. It measures the reduction in the generalized sum of squared residuals
by the introduction of one more lag into the regression. For example, L(k=6) =
? = ? 33.22 = 18.01. If the
Q(K=6) Q{K=i) 51.23 specification is true, L is expected
to be small. Under the null hypothesis, L has a x2 distribution with degrees of
freedom (DF) given by the fourth column. The degrees of freedom for K = 1
(DF = 60) are determined by the difference between the number of instruments
used in the autoregression and the number of parameters estimated, while the
degrees of freedom for K < 7 (DF =10) are determined by the difference between
the number of parameters estimated in autoregressions with lags K and lags K + 1.
The last column gives the significance level by which the specification can be
rejected.

For any given year t, returns from t - 1 to t - K are used as the autoregressors, where
K corresponds to the number of factors in the APT model. K is also the lag length in
the autoregression. For any given year t, returns, firm's B/M ratio, dividend yield, log
capitalization, and E/P ratio from time periods t - 8 to t - 9 are chosen as instruments
to correct for possible correlations between the autoregressors and the error terms in (6).
Q is the generalized sum of squared residuals, corresponding to each specification. L
is the difference in the generalized sum of squared residuals between its corresponding
specification and the specification above it, which has one more lag. If the specification is
correct, L has a x2 distribution with degrees of freedom (DF) given by the fourth column.
P gives the significance level by which the specification can be rejected.

Based on this paper's data capacity, (6) is estimated with K = 1. As Table

1 shows, the hypothesis that Equation (6) might have six or seven lags cannot be
rejected. For example, the L value for K = 6 (18.01) says that K = 6 cannot
be rejected at any significance level less than 5 percent (P = 0.055). But the
specification of K = 5 is strongly rejected (P = 0.000), suggesting Equation (6)
needs at least five lags for the period of 1981-1990. Since the number of lags in the
autoregression corresponds to the number of factors in the APT model, this result
indicates there are at least five systematic factors at work in the market during
this time period, but the contribution of additional factors to the explanation of
cross-sectional variation in returns is statistically insignificant.

B. A Reexamination of Some Firm-Specific Effects

The "firm size effect" was documented by Banz (1981), Keim (1983), Brown,
Kleidon, and Marsh (1983), Fama and French (1992), and Jegadeesh (1992) in their
studies of the CAPM. Whether that "size effect" can be captured by the factor

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 Mei 339

loadings of the APT model is still an unsettled question. In their study of the APT
model, Chen (1983) and Chan, Chen, and Hsieh (1985) found little size effect
after making risk adjustments by the factor loadings.7 In recent works by Connor
and Korajczyk (1988), Lehmann and Modest (1988), Mei (1993), and Shukla and
Trzcinka (1990), using different estimation methods, the size effect was found to
remain in the APT model even after using multiple betas to adjust for systematic
risks.
Using the CAPM, Chan, Hamao, and Lakonishok (1991) studied the B/M
effect extensively for the Japanese market. Fama and French (1992) confirmed a
similar effect in the U.S. market. Basu (1983) found that the E/P ratio also offers
a powerful explanation of expected returns. Numerous studies also found that
dividend yield helps explain the time-variation in expected returns. An interest?
ing question is: does the dividend yield also help to explain the cross-section of
expected returns?
Although previous studies of the multi-factor model examined some of the
above effects separately, this current study extends their works in the following
ways.8 First, this approach does not require the distributional assumptions made
in the maximum-likelihood estimation. Second, little restriction is put on the time
and cross-sectional variation of firm-specific shocks. Third, fairly arbitrary time-
variation is allowed for in factor risk premiums as in Connor and Korajczyk (1988).
Fourth, a large cross-sectional data set is employed. However, this model does
restrict the factor loadings to be constant.
Using the approach developed in Section II, the above effects will be reexam-
ined by testing nt = 0 for various firm-specific variables in the autoregressions of
(8). The firm's B/M ratio, dividend yield, log capitalization, P/E ratio, and returns
from time periods f ? 8 to f ? 9 are used as instrumental variables to correct for
possible correlation between the regressors and the error terms in (8).
Table 3 presents the test statistics for the "size anomaly." Since it cannot
be told exactly how many risk factors there are in the market, nt = 0 will be
tested based on several specifications of K. The second column of Table 3 gives
the generalized sum of squared residuals, Q, of autoregressions (8). The third
column gives the difference in the generalized sum of squared residuals between
the restricted (irt = 0) model (6) and the unrestricted model (8). The generalized
sum of squared residuals of the restricted model, Q, is given in Table 2. Thus,
_ ? 21.72 = 11.50, etC, is
L(K=7,Table3) = Q(K=7, TabJe2) Q(K=7, Table3) = 33.22
calculated. The degrees of freedom (DF) are determined by the difference between
the number of parameters estimated in autoregressions (6) and (8).
From Table 3, it can be seen that nt = 0 is rejected for K < 4 (P = 0.000
for K < 4), but not rejected for K > 5 (P = 0.215, 0.161, 0.319 for K = 5,
6, 7, respectively). So this study's interpretation is that the introduction of more
risk factors into the APT model can eliminate the size effect found in models
7Risk factorswere assumedto be observablein their studies.
8See, for instance, Brown and Weinstein(1982), Burmeisterand McElroy (1988), Chan, Chen,
and Hsieh (1985), Chen, Roll, and Ross (1986), Connorand Korajczyk(1988), Gultekinand Gultekin
(1987), Lehmannand Modest (1988), Jobson (1982), Huberman,Kandel,and Stambaugh(1987), and
Shuklaand Trzcinka(1990).

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340 Journal of Financial and Quantitative Analysis

TABLE3
Test of the Size Anomaly in Autoregression (8)

For any given year t, returns from t? 1 to t? K, and the size from t? 1 as the autoregressors
are used, where K corresponds to the number of factors in the APT model. K is also the lag
length in the autoregression. For any given year t, returns, firm's B/M ratio, dividend yield,
log capitalization, and E/P ratio from time periods t- 8 to t- 9 are chosen as instrumental
variables to correct for possible correlation between the regressors and the error terms in
(8). Q is the generalized sum of squared residuals, corresponding to each specification.
L is the difference in the generalized sum of squared residuals between the specifications
with and without the size variable. If the specification without the size variable is correct,
L has a x2 distribution with degrees of freedom (DF) given by the fourth column. P gives
the significance level by which the specification without the size variable can be rejected.

with fewer risk factors, suggesting that the so called "size anomaly" is due to an
"omitted factors" problem.9
Repeating the same test procedures for the firm's B/M ratio, dividend yield,
and P/E ratio, the findings are summarized in Table 4. One can see clearly that the
"dividend yield effect" is also essentially a misspecification problem, i.e., a failure
to properly account for a variety of systematic risks. As the number of factors is
increased, the "dividend yield effect" becomes insignificant. However, it is found
that the model is incapable of explaining the "B/M ratio effect" and "E/P ratio
effect," even if the number of factors in the model is increased to seven.10 As
pointed out earlier, the introduction of additional factors into a five-factor model
contributes little to the explanation of cross-sectional variation in returns. Thus, the
B/M ratio and E/P ratio variables must possess some unique information besides
exposure to systematic risks, which can help explain the cross-sectional variation
in stock returns.
Table 5 presents the coefficient estimates of Equation (8) for K = 3, which
confirm the findings in Table 3 that 7rr = 0 is rejected for the size variable under
K = 3. From the estimates, it is easy to see that the instrumental variables re?
gression works fairly well since the f-statistics for many estimates are statistically
significant, implying the standard errors for the estimates are relatively small.
If one had poor instruments for the autoregressors, large standard errors (low
f-values) would be expected for the coefficient estimates. It should not be sur-
prising that the coefficients vary over time, because they are functions of factors
and risk premiums (see Equation (5)). Since the firm-specific variables explain
the residual risks in Equation (3), it should not be surprising that the 7rrvary over

9This study's use of annualdata may obscure the size effect in Januaryreturns. Thus, a natural
extension of the paperis to apply the methodology of the paperon monthlydata.
10Thetest resultfor the E/P ratiois interesting.The "E/Pratioeffect"is very strongin the five-factor
model. But the effect becomes insignificantin a six-factor and then becomes significantagain in a
seven-factormodel.

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 Mei 341

time and may not always have the expected signs, because the rjlt in Equation
(8) is a linear combination of current and past residual risks with time-varying
coefficients ipjt (see Equation (7)).

TABLE4
P-Value for the Tests of Some Firm-Specific Effects

K=3 K=4 K=5 K=6 K=7

For any given year t, returns from t - 1 to t ? K and one of the firm-specific variables
from t- 1 are used as the autoregressors, where K corresponds to the factors in the APT
model. For any given year t, returns, firm's B/M ratio, dividend yield, log capitalization, and
E/P ratio from time periods t - 8 to t - 9 are chosen as instrumental variables to correct
for possible correlation between the regressors and the error terms in (8) P gives the
significance level by which the multi-factor model without the firm effects can be rejected

TABLE5
Results for Autoregression (8) with Size Effect (K = 3)

For any given year t, returns from t - 1 to t - K are used as the autoregressors, where
K corresponds to the number of factors in the APT model. For any given year t, returns,
firm's B/M ratio, dividend yield, log capitalization, and E/P ratio from time periods t- 8 to
t- 9 are chosen as instrumental variables to correct for possible correlation between the
regressors and the error terms in (8).

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342 Journal of Financial and Quantitative Analysis

V. Conclusion

This study uses an autoregressive approach to test a multi-factor APT model,

allowing for variable risk premiums. It is found that there are at least five systematic
factors at work in the market during the time period covered by the study. It is also
found that the model is capable of capturing the "size effect" and the "dividend
yield effect" but is incapable of explaining the "B/M effect" and the "E/P ratio
effect." Thus it is concluded that a constant-beta multi-factor model will not be
able to explain the cross-sectional variation in expected returns.
These results are derived from a much simpler framework and easier estima?
tion procedure than those used in previous studies. It is shown that one can test
the central implications of the APT model without going through the tedious and
problematic procedure of estimating assets' betas and factors. The paper makes
no assumptions about the distribution of factors or the constancy of risk premiums.
It also takes advantage of a large cross-sectional data set.

Appendix I

The multi-factor version of Equation (3) for the return-generating process is

(A-l) Rit = Xot + slPi + eit, /=1,...,/V; t=l,...,T.

where st and /?,-are K x 1 column vectors. To extract information about /?/ from
historical return data RiS(s < t), one takes Equation (A-l) for asset / from time
? 1 to t ? K, "stacks" it, moves Xot and ?,-, to the other side, and denotes,
period t
?
S\J-l SKj-l Rut- Ao,f-l Si,t-l
St = nit =
? ?
Slj-K SKjt-K Ri,t-K ^0,t~-K ?i,t-K

St is a K x K matrix and Ilit is a K x 1 vector. Thus, St(3i = IIit.

Assume there are no redundant factors in the model so that St is nonsingular.
Solving for $,

Pi = s-lnit,

and substituting into (A-l) for time period t,

Rit = X0t + JtS~lnit + eit, i = 1,.. ?, N, t = K+\,...,T.

Collecting terms, and defining ip't = (t/jy,..., tpKt) = sftSIl9 gives

Rit = ipot + ^ipjtRij-j + riit, i = l,...,N; t = K+\,...,T,

where
K K
i/>te = Ao5 - ]P ipjt\t-j, Vit = dt ~ ^2 fy&J-b t = K+l,...,T.
7=1 7=1

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 Mei 343

Appendix II

The estimation procedure developed by Holtz-Eakin, Newey and Rosen (1988)

(H, N, & R hereafter), under which autoregression (8) can be estimated and re?
strictions tested, is presented here. Using their notation,

Yt = (RxtiRit* ??? iR-Nt) ? ^/= (Ci,,C2/,... ,C/w)

is written as N x 1 vectors of observations for a given time period f . Let Wt

= (e, Yt-\,..., Yt-K,Xt-\). They are the right side variables of (8). e is a N x 1
vector of ones. Let Ut = (rju, rj2t,..., r]Nt)rbe the transformed error terms, and let
Bt = (ip0t9tpu,..., ipKt97Tty. Then Equation (8) can be written as

(B-l) Y, = W,B, + Ut, t = K+\,...,T.

To combine equation (B-l) over time into a system of equations, Equation

(B-l) is "stacked" by time and denoted

Y = ((T-K)Nxl),
(^+1,...,7f)/;

B = ((T-K)(K+\)x\),
(B'K+X,...,B'T)',

U = ((T-K)Nxl),
(UfK+l,...,U^;

W =
diag(W'K+l,...,W^); ((T - K)N x (T - K)(K + 1)),

where diag (W'K+l,..., W?) denotes a block diagonal matrix with W'K+X,...,W'T
placed on the diagonal. Thus, Equation (8) can be written as

(B-2) Y = WB + U.

To estimate (B-2), H, N, & R proposed a linear 3SLS procedure that is quite

similar to the conventional 3SLS procedure for estimating simultaneous equations.
In the first two stages, a generalized instrumental variable estimation procedure is
used to obtain a consistent estimate of Bt of Equation (B-l) for all time periods,

~X ~*
(B-3) Bt = \w[Zt (Z'tZt) ZftWt] W'tZt (Z'tZt) Z'tYt, t = K+l,...,T,

where Zt is a matrix with variables {<?,Yt^K-\,..., Yt-K-q,Xt-K-\,-.. ,Xt-K-q}

as its column vectors.
At the third stage, the residuals from the above regression, Vt = Yt ? WtBt,
are used to calculate a White-type weighting matrix i? for equation (B-2),
N
(B-4) Qrs =
J2vJ>vp4Zp>
7=1

where ZJt(t - s,r) is the 7th row of Zt and Vjt is the jth element of Vt. Then
the generalized instrumental variable estimation procedure is used again to get a
consistent and more efficient estimate of B in Equation (B-2),

(B-5) B = Z'Y.
\w'Z{Z'zyXZ'w\ W'Z{Z'zyX

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344 Journal of Financial and Quantitative Analysis

Its asymptotic variance and covariance matrix is given by

(B-6) 9 = Var (B) =

[Z,W(f2)~lZ,W]~l.

Equation (6) can be estimated with essentially the same procedure. The tests
of how many lags should be in Equation (8) and whether 7Tt = 0 can be treated
as testing zero constraints on the coefficients of (8). For these problems, the test
strategy is pretty similar to that of the Chow-type test. First, the unrestricted and
the restricted models are estimated and then the difference in the sum of squared
residuals is calculated and compared. It is denoted

(B-7) Q = (Y -WB) /N,

(Y -WB)' Z(nylZ'

which is the generalized sum of squared residuals of system (B-2). L = QR ? Qv

is calculated, where Qr and Qu are, respectively, the generalized sum of squared
residuals of the restricted and unrestricted systems. If the restricted model is true,
L is expected to be small. Under the null hypothesis, L follows a x2 distribution
with degrees of freedom equal to the difference between the number of coefficients
to be estimated in the two systems. Thus, the following testing procedure is used:
if L > La, H0 is rejected. See H, N, & R's paper for details.

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