The Relative Efficiency of Endogenous Proxies: Still Living with the Roll Critique

QAU Working Paper No. QAU07-2
by Todd Prono

An asset pricing restriction that permits inference about the familiar CAPM despite the market return being unobservable is generalized to allow an observable proxy of the market return to be endogenously determined along with the individual asset returns the proxy is supposed to price. Making this allowance reduces the efficiency of the proxy relative to the market return by upwards of 20%. Such a reduction is capable of reversing an inference about the validity of the CAPM theory under the aforementioned pricing restriction. Rendering this pricing restriction feasible empirically is a new method for estimating triangular systems given GARCH errors.

This paper was revised in March 2008.

JEL codes: C13, C32, G12

Keywords: CAPM, GARCH, GMM, triangular systems, endogeneity, identification, conditional heteroskedasticity.

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