“Underconditioning and Overconditioning: Testing the Conditional CAPM and the Conditional Fama-French Three-Factor Model” by Yan LI
This paper proposes a new method to explore the ability of the conditional CAPM and the conditional Fama-French three-factor model to explain asset-pricing anomalies. Central to our approach is using a nonparametric method to find the optimal window size that minimizes both the underconditioning and overconditioning biases. We find that for value-weighted portfolios, the conditional CAPM explains none of the assetpricing anomalies, while the conditional Fama-French three-factor model is able to account for the size effect and the value effect and also helps to explain the momentum effect. For equally-weighted portfolios, however, it is rather difficult for either model to explain return variations. We also find that the conditional Fama-French three-factor model improves upon the conditional CAPM in that it tends to hold for more periods, and its explanatory power is more persistent over time.