Abstract
FOLLOWING THE WORK OF Rubinstein [4], Kraus and Litzenberger (KL) [2] derived and tested a linear three-moment pricing model, finding the additional variable (co-skewness) to explain the empirical anomalies of the two-moment Capital Asset Pricing Model (CAPM). The three-moment model was reexamined by Friend and Westerfield (FW) [1] with mixed results. The purpose of this note is to examine why the market risk premium (RM Rf) may influence tests of asset pricing models with higher moments. When skewness is added to a pricing model developed within the usual two-fund separation assumptions, the market risk premium enters the pricing equation in a nonlinear fashion and is implicit in the estimation of each moment's coefficient. Unless this nonlinearity is recognized, incorrect conclusions regarding the tests of such models may result. Section I examines the implications of the risk premium nonlinearity while Section II contains a brief summary.
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