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Evaluating asset pricing models using the second Hansen-Jagannathan distance

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  • Li, Haitao
  • Xu, Yuewu
  • Zhang, Xiaoyan

Abstract

We develop a specification test and a sequence of model selection procedures for non-nested, overlapping, and nested models based on the second Hansen-Jagannathan distance, which requires a good asset pricing model to not only have small pricing errors but also be arbitrage free. Our methods have reasonably good finite sample performances and are more powerful than existing ones in detecting misspecified models with small pricing errors but are not arbitrage-free and in differentiating models that have similar pricing errors of a given set of test assets. Using the Fama and French size and book-to-market portfolios, we reach dramatically different conclusions on model performances based on our approach and existing methods.

Suggested Citation

  • Li, Haitao & Xu, Yuewu & Zhang, Xiaoyan, 2010. "Evaluating asset pricing models using the second Hansen-Jagannathan distance," Journal of Financial Economics, Elsevier, vol. 97(2), pages 279-301, August.
    • Handle: RePEc:eee:jfinec:v:97:y:2010:i:2:p:279-301
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    Cited by:

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    2. Zhang, Xiang & Liu, Yangyi & Wu, Kun & Maillet, Bertrand, 2021. "Tradable or nontradable factors—what does the Hansen–Jagannathan distance tell us?," International Review of Economics & Finance, Elsevier, vol. 71(C), pages 853-879.
    3. Hammami, Yacine & Lindahl, Anna, 2014. "An intertemporal capital asset pricing model with bank credit growth as a state variable," Journal of Banking & Finance, Elsevier, vol. 39(C), pages 14-28.
    4. Xu, Yuewu & Yao, Xiangkun, 2019. "Extending the Hansen–Jagannathan distance measure of model misspecification," Finance Research Letters, Elsevier, vol. 29(C), pages 384-392.
    5. J. Davies & Jonathan Fletcher & Andrew Marshall, 2015. "Testing index-based models in U.K. stock returns," Review of Quantitative Finance and Accounting, Springer, vol. 45(2), pages 337-362, August.
    6. Sangwon Suh & Wonho Song & Bong-Soo Lee, 2014. "A new method for forming asset pricing factors from firm characteristics," Applied Economics, Taylor & Francis Journals, vol. 46(28), pages 3463-3482, October.
    7. Raymond Kan & Cesare Robotti, 0. "Comment on: Pseudo-True SDFs in Conditional Asset Pricing Models," Journal of Financial Econometrics, Oxford University Press, vol. 18(4), pages 729-735.
    8. Almeida, Caio & Garcia, René, 2012. "Assessing misspecified asset pricing models with empirical likelihood estimators," Journal of Econometrics, Elsevier, vol. 170(2), pages 519-537.
    9. Schneider, Paul, 2015. "Generalized risk premia," Journal of Financial Economics, Elsevier, vol. 116(3), pages 487-504.
    10. Carbajal-De-Nova, Carolina & Venegas-Martínez, Francisco, 2019. "On the paradigm shift of asset pricing models, before and after the global financial crisis: a literature review," Panorama Económico, Escuela Superior de Economía, Instituto Politécnico Nacional, vol. 15(29), pages 7-38, Primer se.
    11. Gospodinov, Nikolay & Kan, Raymond & Robotti, Cesare, 2016. "On the properties of the constrained Hansen–Jagannathan distance," Journal of Empirical Finance, Elsevier, vol. 36(C), pages 121-150.
    12. Wang, Zhenyu & Zhang, Xiaoyan, 2012. "Empirical evaluation of asset pricing models: Arbitrage and pricing errors in contingent claims," Journal of Empirical Finance, Elsevier, vol. 19(1), pages 65-78.
    13. Almeida, Caio & Ardison, Kym & Garcia, René, 2020. "Nonparametric assessment of hedge fund performance," Journal of Econometrics, Elsevier, vol. 214(2), pages 349-378.
    14. Fletcher, Jonathan, 2014. "Benchmark models of expected returns in U.K. portfolio performance: An empirical investigation," International Review of Economics & Finance, Elsevier, vol. 29(C), pages 30-46.
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    16. Nikolay Gospodinov & Raymond Kan & Cesare Robotti, 2010. "On the Hansen-Jagannathan distance with a no-arbitrage constraint," FRB Atlanta Working Paper 2010-04, Federal Reserve Bank of Atlanta.

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