Nonlinearity and Endogeneity in Macro-Asset Pricing

Abstract

Linear asset-pricing relations, with macroeconomic factors as state variables, have found wide usein empirical finance. Applications of such relations range from academic studies of market efficiency andmarket anomalies to practical uses such as risk management and estimation of the cost of capital. Theseapplications make two key assumptions: that the relationship is exclusively linear, and that the macroeconomicfactors are exogenous to returns. For the set of macrofactors commonly used in these applications, bothassumptions run counter to economic intuition. We set out to demonstrate that they are also counter toempirical evidence.We carry out this task using tests for linear and nonlinear Granger causality. We find linear and nonlinearfeedback between stock returns and commonly used macroeconomic pricing factors. We also find linear andnonlinear feedback between residuals from linear pricing relations and returns. In addition, there is littleevidence to suggest that neglected autoregressive or autoregressive conditionally heteroskedastic dynamics areresponsible for these findings, implying that the underlying dynamics are complicated. Thus, linearasset-pricing relations omit interesting and potentially useful aspects of the relationship between stock returnsand the macroeconomy.