Abstract

Linear asset-pricing relations, with macroeconomic factors as state variables, have found wide use

in empirical finance. Applications of such relations range from academic studies of market efficiency and

market anomalies to practical uses such as risk management and estimation of the cost of capital. These

applications make two key assumptions: that the relationship is exclusively linear, and that the macroeconomic

factors are exogenous to returns. For the set of macrofactors commonly used in these applications, both

assumptions run counter to economic intuition. We set out to demonstrate that they are also counter to

empirical evidence.

We carry out this task using tests for linear and nonlinear Granger causality. We find linear and nonlinear

feedback between stock returns and commonly used macroeconomic pricing factors. We also find linear and

nonlinear feedback between residuals from linear pricing relations and returns. In addition, there is little

evidence to suggest that neglected autoregressive or autoregressive conditionally heteroskedastic dynamics are

responsible for these findings, implying that the underlying dynamics are complicated. Thus, linear

asset-pricing relations omit interesting and potentially useful aspects of the relationship between stock returns

and the macroeconomy.

Recommended Citation

Craig Hiemstra and Charles Kramer (1997) "Nonlinearity and Endogeneity in Macro-Asset Pricing ", Studies in Nonlinear Dynamics & Econometrics: Vol. 2: No. 3, Article 1.
http://www.bepress.com/snde/vol2/iss3/art1

Related Files

hiemstra-kramer_datacode.zip (33 kB)
Data & Code