GRS Review

Karl Diether
University of Chicago
Graduate School of Business

Nov 14, 2001

Empirical Implications of the ICAPM

Consider the regressions,

L
Rit R f t = i + i j (Fjt ) + it , i = 1. . .N,
j=1

where,
L 1 is number of priced state variables.
Fj is the excess return (or return from a zero-cost portfolio) on the
jth factor portfolio.
Ri R f is the excess return on a security or portfolio.

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Empirical Implications of the ICAPM
If each factor portfolio is multifactor minimum variance in a S state
variable world then,

1. i = 0 i

2. Some linear combination of the factor portfolios is on the minimum

variance boundary.

There is actually only one implication because i = 0 i if and only if

some portfolio of the right-hand side portfolios is on the minimum
variance boundary.

The GRS Test

1. the GRS test is a statistical test of the hypothesis that i = 0 i.

2. Equivalently, it is a test that some linear combination of the factor

portfolios is on the minimum variance boundary.

3. Equivalently, it is also a test that each factor portfolio is multifactor

minimum variance in a S state variable world.

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GRS Test, Sharpe Ratio Representation

q 2
 
T T N L 1 + 2
N+L
q 1 F(N, T N L)
N T L1 1 + L2

where,

1. N+L is the ex post maximum Sharpe ratio of the N test assets and the
L factor portfolios.

2. L is the ex post maximum Sharpe ratio of the L factor portfolios.

Thus the GRS statistic determines whether |N+L | is statistically greater

than |L |.

Graphical Representation

Mean Variance Frontier

L+N

L
E(R)

RF

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GRS Test, = 0 Representation

    0 1 
T T N L
F(N, T N L)
N T L1 1 + 0 1
where,

1. is a N 1 vector of estimated intercepts.

2. is an unbiased estimate of the residual covariance matrix.

3. is a L 1 vector of the factor portfolios sample means.

4. is an unbiased estimate of the factor portfolios covariance matrix.

if i = 0 i, then the GRS statistic equals zero; the larger the s are in
absolute value the greater the GRS statistic will be.

Computing The GRS Statistic

The problem set will require you to compute a few GRS statistics. You
can compute it using any software package you wish. The following
software packages are commonly used:

Excel

A Matrix Language (i.e. MATLAB, Gauss, or Ox)

It is easier to compute a GRS statistic using a matrix language than it is

using Excel. However, it is probably not worth your time to learn a matrix
language just for this problem set.

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GRS Recipe
Step 1: Time series regressions
Run the following regression for all N left hand side portfolios:

L
Rit R f t = i + i j (Fjt ) + it
j=1

If you are testing the Fama French three factor model then you would run,

Rit R f t = i + bi (RMt R f t ) + si SMBt + hi HMLt + it

GRS Recipe
Step 2: The intercept vector
Form the estimated intercepts into a N 1 vector ().

1

2

=

..



.

N

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GRS Recipe
Step 3: The residual matrix
Calculate the residual for each regression,
L
it = (Rit R f t ) i i j (Fjt ) .
j=1

For example, if you are testing the Fama French three factor model then
you would compute,

it = (Rit R f t ) i bi (RMt R f t ) si SMBt hi HMLt .

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GRS Recipe
Step 3: The residual matrix continued
Form the residuals into a T N matrix (note, that now the first subscript
refers to time period and the second refers to the test portfolio),

12 1N
11
21 22 2N

=
.. .. .. ..

. . . .

T 1 T 2 T N

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GRS Recipe
Step 4: = cov()
Compute an unbiased estimate of the covariance matrix of residuals,

0
=
T L1
is a N N matrix. For example, if there are ten test portfolios, then
is 10 10 matrix.

In Excel you do not have to explicitly compute using the above

formula; you can just use the COVAR command. However, Excels
estimate is not unbiased. You need to multiply Excels estimate by
T /(T L 1).

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GRS Recipe
Step 5: Factor mean vector
Calculate the sample means of the factor portfolios and form a L 1
vector () of sample means.

F1

F2


=
..



.

FL

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GRS Recipe
Step 6: The factor matrix
Form the factor portfolio (excess) returns into a T L matrix (note, that
now the 1st subscript refers to time period and the 2nd refers to the factor
portfolio),

F F12 F1L
11
F21 F22 F2L

F = .. .. .. ..

. . . .

FT 1 FT 2 FT L

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GRS Recipe
Step 7: Compute an unbiased estimate of the covariance matrix of the
factors (the dimension of the covariance matrix is L L),

(F F)0 (F F)
=
T 1
where,
F1 F2 FL

F1 F2 FL


F =
.. .. .. ..


. . . .

F1 F2 FL

Note: In Excel you do not have to explicitly compute using the above
formula; you can just use the COVAR command. However, Excels
estimate is not unbiased. You need to multiply Excels estimate by
T /(T 1).
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GRS Recipe
Step 8: Compute the GRS statistic,

    0 1 
T T N L
F(N, T N L)
N T L1 1 + 0 1

Note: Both 0 1 and 0 1 are scalars. If you do not get scalars, then
you have done something wrong.
Step 9: Find the p-value of the GRS statistic. You can find the p-value in
Excel using the FDIST command.

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