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A Critique of the Stochastic Discount Factor Methodology

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  • Raymond Kan

    (University of Toronto)

  • Guofu Zhou

    (Washington University in St. Louis)

Abstract

In this paper, we point out that the widely used stochastic discount factor (SDF) methodology ignores a fully specified model for asset returns. As a result, it suffers from two potential problems when asset returns follow a linear factor model. The first problem is that the risk premium estimate from the SDF methodology is unreliable. The second problem is that the specification test under the SDF methodology has very low power in detecting misspecified models. Traditional methodologies typically incorporate a fully specified model for asset returns, and they can perform substantially better than the SDF methodology.

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Bibliographic Info

Paper provided by China Economics and Management Academy, Central University of Finance and Economics in its series CEMA Working Papers with number 12.

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Length: 28 pages
Date of creation: 1999
Date of revision:
Publication status: Published in The Journal of Finance, August 1999, Volumn 54, Issue 4, pages 1221-1248
Handle: RePEc:cuf:wpaper:12

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Web page: http://cema.cufe.edu.cn/
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  1. Cochrane, John H, 1996. "A Cross-Sectional Test of an Investment-Based Asset Pricing Model," Journal of Political Economy, University of Chicago Press, University of Chicago Press, vol. 104(3), pages 572-621, June.
  2. Jagannathan, Ravi & Wang, Zhenyu, 1996. " The Conditional CAPM and the Cross-Section of Expected Returns," Journal of Finance, American Finance Association, vol. 51(1), pages 3-53, March.
  3. Zhou, Guofu, 1994. "Analytical GMM Tests: Asset Pricing with Time-Varying Risk Premiums," Review of Financial Studies, Society for Financial Studies, vol. 7(4), pages 687-709.
  4. Hansen, Lars Peter & Jagannathan, Ravi, 1991. "Implications of Security Market Data for Models of Dynamic Economies," Journal of Political Economy, University of Chicago Press, University of Chicago Press, vol. 99(2), pages 225-62, April.
  5. Harvey, Campbell R. & Zhou, Guofu, 1993. "International asset pricing with alternative distributional specifications," Journal of Empirical Finance, Elsevier, Elsevier, vol. 1(1), pages 107-131, June.
  6. Merton, Robert C, 1973. "An Intertemporal Capital Asset Pricing Model," Econometrica, Econometric Society, Econometric Society, vol. 41(5), pages 867-87, September.
  7. Black, Fischer, 1972. "Capital Market Equilibrium with Restricted Borrowing," The Journal of Business, University of Chicago Press, vol. 45(3), pages 444-55, July.
  8. Hansen, Lars Peter, 1982. "Large Sample Properties of Generalized Method of Moments Estimators," Econometrica, Econometric Society, Econometric Society, vol. 50(4), pages 1029-54, July.
  9. Ross, Stephen A., 1976. "The arbitrage theory of capital asset pricing," Journal of Economic Theory, Elsevier, vol. 13(3), pages 341-360, December.
  10. K. Newey, Whitney, 1985. "Generalized method of moments specification testing," Journal of Econometrics, Elsevier, vol. 29(3), pages 229-256, September.
  11. Zhou, Guofu, 1991. "Small sample tests of portfolio efficiency," Journal of Financial Economics, Elsevier, vol. 30(1), pages 165-191, November.
  12. Lars Peter Hansen & Ravi Jagannathan, 1994. "Assessing Specification Errors in Stochastic Discount Factor Models," NBER Technical Working Papers 0153, National Bureau of Economic Research, Inc.
  13. Zhou, Guofu, 1995. "Small sample rank tests with applications to asset pricing," Journal of Empirical Finance, Elsevier, Elsevier, vol. 2(1), pages 71-93, March.
  14. Kan, Raymond & Zhang, Chu, 1999. "GMM tests of stochastic discount factor models with useless factors," Journal of Financial Economics, Elsevier, vol. 54(1), pages 103-127, October.
  15. Breeden, Douglas T., 1979. "An intertemporal asset pricing model with stochastic consumption and investment opportunities," Journal of Financial Economics, Elsevier, vol. 7(3), pages 265-296, September.
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