An Exact Bayes Test of Asset Pricing Models with Application to International Markets*

This paper develops and implements an exact finite-sample test of asset pricing models with time-varying risk premia using posterior probabilities. The strength of our approach is that it allows multiple conditional asset pricing specifications, both nested and nonnested, to be tested and compared simultaneously. We apply our procedure to international equity markets by testing and comparing the international Capital Asset Pricing Model (ICAPM) and conditional ICAPM versions of Fama and French (1998). The empirical evidence suggests that the best performing model is the ICAPM with the value premium constructed based on global earnings-to-price ratio.