Abstract
ABSTRACTWe argue that arbitrage‐pricing theories (APT) imply the existence of a low‐dimensional nonnegative nonlinear pricing kernel. In contrast to standard constructs of the APT, we do not assume a linear factor structure on the payoffs. This allows us to price both primitive and derivative securities. Semi‐nonparametric techniques are used to estimate the pricing kernel and test the theory. Empirical results using size‐based portfolio returns and yields on bonds reject the nested capital asset‐pricing model and linear APT and support the nonlinear APT. Diagnostics show that the nonlinear model is more capable of explaining variations in small firm returns.
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