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What Difference Fat Tails Make: A Bayesian MCMC Estimation of Empirical Asset Pricing Models

This chapter presents an empirical application of Bayesian MCMC estimation to the three main asset pricing models in use in the financial econometrics literature, namely, the Capital Asset Pricing Model (CAPM), the Fama-French (1992) three-factor model, and the Carhart (1997) four-factor model for decile portfolios sorted on market capitalization and book-to-market ratios. I use a SUR model similar in spirit to Zellner (1976) with a Student t-link to allow for fat tails in the distribution of the return innovations. The empirical findings are encouraging in that fat tails lead to posterior distributions of the asset pricing errors that encompass zero and indicate that previous findings of statistically and economically significant intercepts might be an artifact of using a Gaussian error distribution.