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.
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Paper provided by University of Iowa, Department of Economics in its series Working Papers with number
99-01.
Length: 31 pages Date of creation: Aug 1998 Date of revision:
Jan 1999 Handle: RePEc:uia:iowaec:99-01
Contact details of provider: Postal: University of Iowa, Department of Economics, Henry B. Tippie College of Business, Iowa City, Iowa 52242 Phone: (319) 335-0829 Fax: (319) 335-1956 Web page: http://tippie.uiowa.edu/economics/ More information through EDIRC
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Find related papers by JEL classification: G12 - Financial Economics - - General Financial Markets - - - Asset Pricing E21 - Macroeconomics and Monetary Economics - - Macroeconomics: Consumption, Saving, Production, Employment, and Investment - - - Consumption; Saving; Wealth E43 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Determination of Interest Rates; Term Structure of Interest Rates
References listed on IDEAS Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
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.
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