A Combined Approach to the Inference of Conditional Factor Models

We propose a two-stage procedure that naturally unifies the two existing approaches in the finance literature—the parametric approach and the nonparametric approach. Our combined approach possesses important advantages over both methods.

Using our two-stage combined estimator, we derive new test statistics for investigating key hypotheses in the context of conditional factor models. Our tests can be performed on a single asset or jointly across multiple assets. We further propose a novel test to directly check whether the parametric model used in our first stage is correctly specified.