TESTS OF THE RELATIONS AMONG MARKETWIDE FACTORS, FIRM-SPECIFIC VARIABLES, AND STOCK RETURNS USING A CONDITIONAL ASSET PRICING MODEL

In this article we generalize Harvey's (1989) empirical specification of conditional asset pricing models to allow for both time-varying cav ariances between stock returns and marketwide factors and time-varying reward-to-covariabilities. The model is then applied to examine the e ffects of firm size and book-to-market equity ratios. We find that the traditional asset pricing model with commonly used factors can only e xplain a small portion of the stack returns predicted by firm size and book-to-market equity ratios. The results indicate that allowing time -varying covariances and time-varying reward-to-covariabilities does l ittle to salvage the traditional asset pricing models.