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Evaluating Asset Pricing Models in a Fama-French Framework

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  • Carlos Enrique Carrasco Gutierrez
  • Wagner Piazza Gaglianone

Abstract

In this work we propose a methodology to compare different stochastic discount factor (SDF) proxies based on relevant market information. The starting point is the work of Fama and French, which evidenced that the asset returns of the U.S. economy could be explained by relative factors linked to characteristics of the firms. In this sense, we construct a Monte Carlo simulation to generate a set of returns perfectly compatible with the Fama and French factors and, then, investigate the performance of different SDF proxies. Some goodness-of-fit statistics and the Hansen and Jagannathan distance are used to compare asset pricing models. An empirical application of our setup is also provided.

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File URL: http://www.bcb.gov.br/pec/wps/ingl/wps175.pdf
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Bibliographic Info

Paper provided by Central Bank of Brazil, Research Department in its series Working Papers Series with number 175.

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Date of creation: Dec 2008
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Handle: RePEc:bcb:wpaper:175

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Web page: http://www.bcb.gov.br/?english

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  1. John M. Griffin, 2002. "Are the Fama and French Factors Global or Country Specific?," Review of Financial Studies, Society for Financial Studies, vol. 15(3), pages 783-803.
  2. Araújo, Fabio & Issler, João Victor & Fernandes, Marcelo, 2005. "Estimating the Stochastic Discount Factor without a Utility Function," Economics Working Papers (Ensaios Economicos da EPGE) 583, FGV/EPGE Escola Brasileira de Economia e Finanças, Getulio Vargas Foundation (Brazil).
  3. Wayne E. Ferson & Campbell R. Harvey, 1999. "Conditioning Variables and the Cross-Section of Stock Returns," NBER Working Papers 7009, National Bureau of Economic Research, Inc.
  4. Raymond Kan & Cesare Robotti, 2007. "Model comparison using the Hansen-Jagannathan distance," Working Paper 2007-04, Federal Reserve Bank of Atlanta.
  5. Jagannathan, Ravi & Kubota, Keiichi & Takehara, Hitoshi, 1998. "Relationship between Labor-Income Risk and Average Return: Empirical Evidence from the Japanese Stock Market," The Journal of Business, University of Chicago Press, vol. 71(3), pages 319-47, July.
  6. Ravi Jagannathan & Zhenyu Wang, 2001. "Empirical Evaluation of Asset Pricing Models: A Comparison of the SDF and Beta Methods," NBER Working Papers 8098, National Bureau of Economic Research, Inc.
  7. Clive Gaunt, 2004. "Size and book to market effects and the Fama French three factor asset pricing model: evidence from the Australian stockmarket," Accounting and Finance, Accounting and Finance Association of Australia and New Zealand, vol. 44(1), pages 27-44.
  8. Newey, Whitney K & West, Kenneth D, 1994. "Automatic Lag Selection in Covariance Matrix Estimation," Review of Economic Studies, Wiley Blackwell, vol. 61(4), pages 631-53, October.
  9. Heber Farnsworth, 2002. "Performance Evaluation with Stochastic Discount Factors," The Journal of Business, University of Chicago Press, vol. 75(3), pages 473-504, July.
  10. Wayne E. Ferson & Campbell R. Harvey, 1994. "Sources of Risk and Expected Returns in Global Equity Markets," NBER Working Papers 4622, National Bureau of Economic Research, Inc.
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