NO ARBITRAGE AND ARBITRAGE PRICING - A NEW APPROACH

We argue that arbitrage-pricing theories (APT) imply the existence of a low-dimensional nonnegative nonlinear pricing kernel. In contrast to standard constructs of the APT, we do not assume a linear factor stru cture on the payoffs. This allows us to price both primitive and deriv ative securities. Semi-nonparametric techniques are used to estimate t he pricing kernel and test the theory. Empirical results using size-ba sed portfolio returns and yields on bonds reject the nested capital as set-pricing model and linear APT and support the nonlinear APT. Diagno stics show that the nonlinear model is more capable of explaining vari ations in small firm returns.