Multivariate proxies and asset pricing relations

Abstract

A framework is developed in which inferences can be made about the validity of an equilibrium asset pricing relation, even though the central aggregate in this relation is unobservable. A multivariate proxy for the true market portfolio, consisting of an equal-weighted stock index and a long-term government bond index, is employed in an investigation of the Sharpe-Lintner CAPM. The empirical evidence suggests that we can reject the joint hypothesis that (a) CAPM is valid, and (b) multiple correlation between the true market portfolio and proxy assets exceeds 0.7. Connections to the equilibrium factor pricing literature are also explored.