Bounds on the Variances of Specification Errors in Models with Expectations
NBER Working Paper No. 2936
Under rather general conditions, observed covariances place a useful lower bound on the variance of the misspecification or noise III models based on expectations. Such models are widely used for securities prices, exchange rates, consumption, and output. For a correctly specified model, the lower bound will be zero. We construct an optimal bound on model noise that captures the complete set of testable restrictions on an expectations based model. Many specification tests for asset prices are easily interpreted as estimates of this lower bound. As a result, the power of different tests may be ranked according to the information restrictions employed in constructing noise estimates. Our results show that specification tests which use the history of lagged dependent variables are usually better able to uncover model noise than based on information sets that exclude those variables.