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A Rehabilitation of Stochastic Discount Factor Methodology

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  • John H. Cochrane

Abstract

In a recent Journal of Finance article, Kan and Zhou (1999) find that the 'Stochastic discount factor' methodology using GMM is markedly inferior to traditional maximum likelihood even in a simple test of the static CAPM with i.i.d. normal returns. This result has gained wide attention. However, as Jagannathan and Wang (2001) point out, this result flows from a strange assumption: Kan and Zhou allow the ML estimate to know the mean market return ex-ante. I show how this information advantage explains Kan and Zhou's results. In fact, when treated symmetrically, the discount factor - GMM and traditional methodologies behave almost identically in linear i.i.d. environments.

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Bibliographic Info

Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 8533.

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Date of creation: Oct 2001
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Handle: RePEc:nbr:nberwo:8533

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  1. Raymond Kan & Guofu Zhou, 1999. "A Critique of the Stochastic Discount Factor Methodology," Journal of Finance, American Finance Association, vol. 54(4), pages 1221-1248, 08.
  2. Cochrane, John H, 1996. "A Cross-Sectional Test of an Investment-Based Asset Pricing Model," Journal of Political Economy, University of Chicago Press, vol. 104(3), pages 572-621, June.
  3. 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.
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Cited by:
  1. Smith, Peter & Wickens, Michael, 2002. " Asset Pricing with Observable Stochastic Discount Factors," Journal of Economic Surveys, Wiley Blackwell, vol. 16(3), pages 397-446, July.
  2. Bansal, Ravi & Dahlquist, Magnus, 2002. "Expropriation Risk and Return in Global Equity Markets," SIFR Research Report Series 8, Institute for Financial Research.
  3. Smith, Peter N & Wickens, Michael R, 2002. "Macroeconomic Sources of FOREX Risk," CEPR Discussion Papers 3148, C.E.P.R. Discussion Papers.
  4. Dahlquist, Magnus & Sallstrom, Torbjorn, 2002. "An Evaluation of International Asset Pricing Models," CEPR Discussion Papers 3145, C.E.P.R. Discussion Papers.

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