IDEAS home Printed from https://ideas.repec.org/p/uia/iowaec/99-01.html
   My bibliography  Save this paper

Evaluating Asset-Pricing Models Using The Hansen-Jagannathan Bound: A Monte Carlo Investigation

Author

Listed:
  • Otrok, Christopher

    (University of Virginia)

  • Ravikumar, B.

    (University of Iowa)

  • Whiteman, Charles H.

    (University of Iowa)

Abstract

We conduct Monte Carlo experiments to examine whether the Hansen and Jagannathan (1991) bound is a useful device for evaluating asset pricing models. Specifically, we use recently developed statistical tests, which are based on a 'distance' between the model and the Hansen-Jagannathan bound, to compute the rejection rates of true models. We first demonstrate that previous Monte Carlo assessments suffer from subtle computational and conceptual errors. We then provide correct finite-sample critical values for asset pricing models with time separable preferences, and show how they depend upon nuisance parameters-risk aversion and the rate of time preference. Further, we show that the finite-sample distribution of the test statistic associated with the risk-neutral case is extreme, in the sense that critical values based on this distribution will deliver type I errors no larger than intended-regardless of risk aversion or the rate of time preference. Extending the analysis to accommodate other preferences, we show that in the state non-separable case, the small-sample distributions of the test statistics are influenced significantly by the degree of intertemporal substitution, but not by attitudes toward risk. For habit formation preferences, the small sample distributions are strongly influenced by the habit parameter. However, the maximal size critical values for time-separable preferences are appropriate for habit formation as well as state non-separable preferences. We conclude that with these critical values the HJ bound is indeed a useful evaluation device.

Suggested Citation

  • Otrok, Christopher & Ravikumar, B. & Whiteman, Charles H., 1998. "Evaluating Asset-Pricing Models Using The Hansen-Jagannathan Bound: A Monte Carlo Investigation," Working Papers 99-01, University of Iowa, Department of Economics, revised Jan 1999.
  • Handle: RePEc:uia:iowaec:99-01
    as

    Download full text from publisher

    File URL: http://www.biz.uiowa.edu/econ/econinst/papers/hjmc.pdf
    Download Restriction: no
    ---><---

    Other versions of this item:

    References listed on IDEAS

    as
    1. Cecchetti, Stephen G & Lam, Pok-sang & Mark, Nelson C, 1994. "Testing Volatility Restrictions on Intertemporal Marginal Rates of Substitution Implied by Euler Equations and Asset Returns," Journal of Finance, American Finance Association, vol. 49(1), pages 123-152, March.
    2. Mehra, Rajnish & Prescott, Edward C., 1985. "The equity premium: A puzzle," Journal of Monetary Economics, Elsevier, vol. 15(2), pages 145-161, March.
    3. Otrok, Christopher & Ravikumar, B. & Whiteman, Charles H., 2002. "Habit formation: a resolution of the equity premium puzzle?," Journal of Monetary Economics, Elsevier, vol. 49(6), pages 1261-1288, September.
    4. Hansen, Lars Peter, 1982. "Large Sample Properties of Generalized Method of Moments Estimators," Econometrica, Econometric Society, vol. 50(4), pages 1029-1054, July.
    5. Abel, Andrew B, 1990. "Asset Prices under Habit Formation and Catching Up with the Joneses," American Economic Review, American Economic Association, vol. 80(2), pages 38-42, May.
    6. Hansen, Lars Peter & Jagannathan, Ravi, 1997. "Assessing Specification Errors in Stochastic Discount Factor Models," Journal of Finance, American Finance Association, vol. 52(2), pages 557-590, June.
    7. Weil, Philippe, 1989. "The equity premium puzzle and the risk-free rate puzzle," Journal of Monetary Economics, Elsevier, vol. 24(3), pages 401-421, November.
    8. Hansen, Lars Peter & Jagannathan, Ravi, 1991. "Implications of Security Market Data for Models of Dynamic Economies," Journal of Political Economy, University of Chicago Press, vol. 99(2), pages 225-262, April.
    9. Sundaresan, Suresh M, 1989. "Intertemporally Dependent Preferences and the Volatility of Consumption and Wealth," Review of Financial Studies, Society for Financial Studies, vol. 2(1), pages 73-89.
    10. Larry G. Epstein & Stanley E. Zin, 2013. "Substitution, risk aversion and the temporal behavior of consumption and asset returns: A theoretical framework," World Scientific Book Chapters, in: Leonard C MacLean & William T Ziemba (ed.), HANDBOOK OF THE FUNDAMENTALS OF FINANCIAL DECISION MAKING Part I, chapter 12, pages 207-239, World Scientific Publishing Co. Pte. Ltd..
    11. Lucas, Robert E, Jr, 1978. "Asset Prices in an Exchange Economy," Econometrica, Econometric Society, vol. 46(6), pages 1429-1445, November.
    12. John Y. Campbell & John Cochrane, 1999. "Force of Habit: A Consumption-Based Explanation of Aggregate Stock Market Behavior," Journal of Political Economy, University of Chicago Press, vol. 107(2), pages 205-251, April.
    13. Tauchen, George, 1986. "Finite state markov-chain approximations to univariate and vector autoregressions," Economics Letters, Elsevier, vol. 20(2), pages 177-181.
    14. Heaton, John, 1995. "An Empirical Investigation of Asset Pricing with Temporally Dependent Preference Specifications," Econometrica, Econometric Society, vol. 63(3), pages 681-717, May.
    15. Constantinides, George M, 1990. "Habit Formation: A Resolution of the Equity Premium Puzzle," Journal of Political Economy, University of Chicago Press, vol. 98(3), pages 519-543, June.
    16. Hansen, Lars Peter & Heaton, John & Luttmer, Erzo G J, 1995. "Econometric Evaluation of Asset Pricing Models," Review of Financial Studies, Society for Financial Studies, vol. 8(2), pages 237-274.
    17. Gregory, Allan W. & Smith, Gregor W., 1992. "Sampling variability in Hansen-Jagannathan bounds," Economics Letters, Elsevier, vol. 38(3), pages 263-267, March.
    18. Abel, Andrew B., 1999. "Risk premia and term premia in general equilibrium," Journal of Monetary Economics, Elsevier, vol. 43(1), pages 3-33, February.
    19. John H. Cochrane & Lars Peter Hansen, 1992. "Asset Pricing Explorations for Macroeconomics," NBER Chapters, in: NBER Macroeconomics Annual 1992, Volume 7, pages 115-182, National Bureau of Economic Research, Inc.
    20. Burnside, Craig, 1994. "Hansen-Jagannathan Bounds as Classical Tests of Asset-Pricing Models," Journal of Business & Economic Statistics, American Statistical Association, vol. 12(1), pages 57-79, January.
    21. Hansen, Lars Peter & Singleton, Kenneth J, 1982. "Generalized Instrumental Variables Estimation of Nonlinear Rational Expectations Models," Econometrica, Econometric Society, vol. 50(5), pages 1269-1286, September.
    Full references (including those not matched with items on IDEAS)

    Citations

    Citations are extracted by the CitEc Project, subscribe to its RSS feed for this item.
    as


    Cited by:

    1. Raymond Kan & Cesare Robotti, 2016. "The Exact Distribution of the Hansen–Jagannathan Bound," Management Science, INFORMS, vol. 62(7), pages 1915-1943, July.
    2. Raymond Kan & Cesare Robotti, 2008. "The exact distribution of the Hansen-Jagannathan bound," FRB Atlanta Working Paper 2008-09, Federal Reserve Bank of Atlanta.
    3. Qiang Zhang, 2004. "Accounting for Human Capital and Weak Identification in Evaluating the Esptein-Zin-Weil Non-Expected Utility Model of Asset Pricing," CIRJE F-Series CIRJE-F-289, CIRJE, Faculty of Economics, University of Tokyo.
    4. Houssa, Romain, 2013. "Uncertainty about welfare effects of consumption fluctuations," European Economic Review, Elsevier, vol. 59(C), pages 35-62.
    5. Silos, Pedro, 2006. "Assessing Markov chain approximations: A minimal econometric approach," Journal of Economic Dynamics and Control, Elsevier, vol. 30(6), pages 1063-1079, June.
    6. Christopher Otrok & B. Ravikumar, 2020. "Asset Pricing Through the Lens of the Hansen-Jagannathan Bound," Review, Federal Reserve Bank of St. Louis, vol. 102(3), pages 255-269, July.
    7. Engsted, Tom, 2002. "Measures of Fit for Rational Expectations Models," Journal of Economic Surveys, Wiley Blackwell, vol. 16(3), pages 301-355, July.
    8. Jeon, Junkee & Koo, Hyeng Keun & Shin, Yong Hyun, 2018. "Portfolio selection with consumption ratcheting," Journal of Economic Dynamics and Control, Elsevier, vol. 92(C), pages 153-182.
    9. Otrok, Christopher & Ravikumar, B & Whiteman, Charles, 2001. "Stochastic Discount Factor Models and the Equity Premium Puzzle," MPRA Paper 22938, University Library of Munich, Germany, revised Nov 2004.

    Most related items

    These are the items that most often cite the same works as this one and are cited by the same works as this one.
    1. Liu, Ludan, 2008. "It takes a model to beat a model: Volatility bounds," Journal of Empirical Finance, Elsevier, vol. 15(1), pages 80-110, January.
    2. Kris Jacobs, 2002. "The Rate of Risk Aversion May Be Lower Than You Think," CIRANO Working Papers 2002s-08, CIRANO.
    3. Otrok, Christopher & Ravikumar, B. & Whiteman, Charles H., 2007. "A generalized volatility bound for dynamic economies," Journal of Monetary Economics, Elsevier, vol. 54(8), pages 2269-2290, November.
    4. John Y. Campbell, 2000. "Asset Pricing at the Millennium," Journal of Finance, American Finance Association, vol. 55(4), pages 1515-1567, August.
    5. Ludvigson, Sydney C., 2013. "Advances in Consumption-Based Asset Pricing: Empirical Tests," Handbook of the Economics of Finance, in: G.M. Constantinides & M. Harris & R. M. Stulz (ed.), Handbook of the Economics of Finance, volume 2, chapter 0, pages 799-906, Elsevier.
    6. Kris Jacobs, 2001. "Estimating Nonseparable Preference Specifications for Asset Market Participants," CIRANO Working Papers 2001s-12, CIRANO.
    7. Chrétien, Stéphane, 2012. "Bounds on the autocorrelation of admissible stochastic discount factors," Journal of Banking & Finance, Elsevier, vol. 36(7), pages 1943-1962.
    8. John Donaldson & Rajnish Mehra, 2007. "Risk Based Explanations of the Equity Premium," NBER Working Papers 13220, National Bureau of Economic Research, Inc.
    9. Cochrane, John H., 2005. "Financial Markets and the Real Economy," Foundations and Trends(R) in Finance, now publishers, vol. 1(1), pages 1-101, July.
    10. Committee, Nobel Prize, 2013. "Understanding Asset Prices," Nobel Prize in Economics documents 2013-1, Nobel Prize Committee.
    11. Kris Jacobs & Kevin Q. Wang, 2002. "Idiosyncratic Consumption Risk and the Cross-Section of Asset Returns," CIRANO Working Papers 2002s-11, CIRANO.
    12. Jacobs, Kris, 2000. "Estimating Nonseparable Preference Specifications for Asset Market Participants," Econometric Society World Congress 2000 Contributed Papers 1472, Econometric Society.
    13. Wayne E. Ferson & Ravi Jagannathan, 1996. "Econometric evaluation of asset pricing models," Staff Report 206, Federal Reserve Bank of Minneapolis.
    14. Bakshi, Gurdip S. & Naka, Atsuyuki, 1997. "An empirical investigation of asset pricing models using Japanese stock market data," Journal of International Money and Finance, Elsevier, vol. 16(1), pages 81-112, February.
    15. Hansen, Lars Peter, 2013. "Uncertainty Outside and Inside Economic Models," Nobel Prize in Economics documents 2013-7, Nobel Prize Committee.
    16. Bekaert, Geert & Engstrom, Eric & Grenadier, Steven R., 2010. "Stock and bond returns with Moody Investors," Journal of Empirical Finance, Elsevier, vol. 17(5), pages 867-894, December.
    17. Xiaohong Chen & Sydney C. Ludvigson, 2009. "Land of addicts? an empirical investigation of habit-based asset pricing models," Journal of Applied Econometrics, John Wiley & Sons, Ltd., vol. 24(7), pages 1057-1093.
    18. Michele Boldrin & Lawrence J. Christiano & Jonas D.M. Fisher, 1995. "Asset Pricing Lessons for Modeling Business Cycles," NBER Working Papers 5262, National Bureau of Economic Research, Inc.
    19. Nader Shahzad Virk, 2013. "Evidence for state and time nonseparable preferences: the case of Finland," Applied Financial Economics, Taylor & Francis Journals, vol. 23(24), pages 1821-1838, December.
    20. Lars Peter Hansen & Thomas J Sargent, 2014. "Robust Permanent Income and Pricing," World Scientific Book Chapters, in: UNCERTAINTY WITHIN ECONOMIC MODELS, chapter 3, pages 33-81, World Scientific Publishing Co. Pte. Ltd..

    More about this item

    Keywords

    Equity Premium; Asset Pricing; Spectral Analysis;
    All these keywords.

    JEL classification:

    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • E21 - Macroeconomics and Monetary Economics - - Consumption, Saving, Production, Employment, and Investment - - - Consumption; Saving; Wealth
    • E43 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Interest Rates: Determination, Term Structure, and Effects

    Statistics

    Access and download statistics

    Corrections

    All material on this site has been provided by the respective publishers and authors. You can help correct errors and omissions. When requesting a correction, please mention this item's handle: RePEc:uia:iowaec:99-01. See general information about how to correct material in RePEc.

    If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.

    If CitEc recognized a bibliographic reference but did not link an item in RePEc to it, you can help with this form .

    If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your RePEc Author Service profile, as there may be some citations waiting for confirmation.

    For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: None (email available below). General contact details of provider: https://edirc.repec.org/data/deuiaus.html .

    Please note that corrections may take a couple of weeks to filter through the various RePEc services.

    IDEAS is a RePEc service. RePEc uses bibliographic data supplied by the respective publishers.