A macroeconomic factor test of the arbitrage pricing theory

An Iterated-Nonlinear-Seemingly-Unrelated-Regression Model with derived-macroeconomic factors was used to test the Arbitrage Pricing Theory. These derived macroeconomic factors (exogenous variables) were estimated by applying Principal-Components Analysis to a set of ten macroeconomic time-series residuals and five sets of residual portfolio returns (constructed to be orthogonal to the macroeconomic residuals). This specification reduces errors-in-variables that result when macroeconomic factors are estimated through the factor structure of security returns or defined by macroeconomic variables.