Testing Beta-Pricing Models Using Large Cross-Sections

We propose a methodology for estimating and testing beta-pricing models when a large number of assets is available for investment but the number of time-series observations is fixed. We first consider the case of correctly specified models with constant risk premia, and then extend our framework to deal with time-varying risk premia, potentially misspecified models, firm characteristics, and unbalanced panels. We show that our large cross-sectional framework poses a serious challenge to common empirical findings regarding the validity of beta-pricing models. In the context of pricing models with Fama-French factors, firm characteristics are found to explain a much larger proportion of variation in estimated expected returns than betas.