Coskewness and its Implications for Testing Asset Pricing Models

In this paper we investigate portfolio coskewness using a quadratic market model as return generating process. It is shown that portfolios of small (large) firms have negative (positive) coskewness with market. An asset pricing model including coskewness is tested through the restrictions it imposes on the return generating process. Although the model is statistically rejected, we show that the unexplained component in expected excess returns is constant across portfolios in our sample, and modest in magnitude. We investigate the implications of erroneously neglecting coskewness for testing asset pricing models, with particular interest for the empirically detected explanatory power of size.