IDEAS home Printed from
   My bibliography  Save this article

A Critique of the Stochastic Discount Factor Methodology


  • Raymond Kan

    (University of Toronto,)

  • Guofu Zhou

    (Washington University in St. Louis)


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. Copyright The American Finance Association 1999.

Suggested Citation

  • 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, August.
  • Handle: RePEc:bla:jfinan:v:54:y:1999:i:4:p:1221-1248

    Download full text from publisher

    File URL:
    File Function: link to full text
    Download Restriction: Access to full text is restricted to subscribers.

    As the access to this document is restricted, you may want to look for a different version below or search for a different version of it.

    Other versions of this item:

    References listed on IDEAS

    1. Hansen, Lars Peter, 1982. "Large Sample Properties of Generalized Method of Moments Estimators," Econometrica, Econometric Society, vol. 50(4), pages 1029-1054, July.
    2. 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.
    3. 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.
    4. Ross, Stephen A., 1976. "The arbitrage theory of capital asset pricing," Journal of Economic Theory, Elsevier, vol. 13(3), pages 341-360, December.
    5. 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.
    6. Harvey, Campbell R. & Zhou, Guofu, 1993. "International asset pricing with alternative distributional specifications," Journal of Empirical Finance, Elsevier, vol. 1(1), pages 107-131, June.
    7. K. Newey, Whitney, 1985. "Generalized method of moments specification testing," Journal of Econometrics, Elsevier, vol. 29(3), pages 229-256, September.
    8. 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.
    9. Merton, Robert C, 1973. "An Intertemporal Capital Asset Pricing Model," Econometrica, Econometric Society, vol. 41(5), pages 867-887, September.
    10. 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.
    11. Zhou, Guofu, 1995. "Small sample rank tests with applications to asset pricing," Journal of Empirical Finance, Elsevier, vol. 2(1), pages 71-93, March.
    12. 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.
    13. Zhou, Guofu, 1991. "Small sample tests of portfolio efficiency," Journal of Financial Economics, Elsevier, vol. 30(1), pages 165-191, November.
    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. Black, Fischer, 1972. "Capital Market Equilibrium with Restricted Borrowing," The Journal of Business, University of Chicago Press, vol. 45(3), pages 444-455, July.
    Full references (including those not matched with items on IDEAS)


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

    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. Eric Jondeau & Michael Rockinger, 2006. "Optimal Portfolio Allocation under Higher Moments," European Financial Management, European Financial Management Association, vol. 12(1), pages 29-55.
    3. Jondeau, E. & Rockinger, M., 2000. "Conditional Volatility, Skewness, and Kurtosis: Existence and Persistence," Working papers 77, Banque de France.
    4. Khan, Mozaffar, 2008. "Are accruals mispriced Evidence from tests of an Intertemporal Capital Asset Pricing Model," Journal of Accounting and Economics, Elsevier, vol. 45(1), pages 55-77, March.
    5. repec:ebl:ecbull:v:3:y:2005:i:10:p:1-13 is not listed on IDEAS
    6. Ahmed, Shamim & Liu, Xiaoquan & Valente, Giorgio, 2016. "Can currency-based risk factors help forecast exchange rates?," International Journal of Forecasting, Elsevier, vol. 32(1), pages 75-97.
    7. Jondeau, Eric & Rockinger, Michael, 2003. "Conditional volatility, skewness, and kurtosis: existence, persistence, and comovements," Journal of Economic Dynamics and Control, Elsevier, vol. 27(10), pages 1699-1737, August.
    8. Shanken, Jay & Zhou, Guofu, 2007. "Estimating and testing beta pricing models: Alternative methods and their performance in simulations," Journal of Financial Economics, Elsevier, vol. 84(1), pages 40-86, April.
    9. Ravi Jagannathan & Zhenyu Wang, 2002. "Empirical Evaluation of Asset-Pricing Models: A Comparison of the SDF and Beta Methods," Journal of Finance, American Finance Association, vol. 57(5), pages 2337-2367, October.
    10. Kan, Raymond & Robotti, Cesare, 2008. "Specification tests of asset pricing models using excess returns," Journal of Empirical Finance, Elsevier, vol. 15(5), pages 816-838, December.
    11. Heber Farnsworth & Wayne E. Ferson & David Jackson & Steven Todd, 2002. "Performance Evaluation with Stochastic Discount Factors," NBER Working Papers 8791, National Bureau of Economic Research, Inc.
    12. Cai, Zongwu & Hong, Yongmiao, 2003. "Nonparametric Methods in Continuous-Time Finance: A Selective Review," SFB 373 Discussion Papers 2003,15, Humboldt University of Berlin, Interdisciplinary Research Project 373: Quantification and Simulation of Economic Processes.
    13. John H. Cochrane, 2001. "A Rehabilitation of Stochastic Discount Factor Methodology," NBER Working Papers 8533, National Bureau of Economic Research, Inc.
    14. Driessen, Joost & Melenberg, Bertrand & Nijman, Theo, 2005. "Testing affine term structure models in case of transaction costs," Journal of Econometrics, Elsevier, vol. 126(1), pages 201-232, May.
    15. Bartram, Söhnke M. & Bodnar, Gordon M., 2012. "Crossing the lines: The conditional relation between exchange rate exposure and stock returns in emerging and developed markets," Journal of International Money and Finance, Elsevier, vol. 31(4), pages 766-792.
    16. Lozano, Martín & Rubio, Gonzalo, 2011. "Evaluating alternative methods for testing asset pricing models with historical data," Journal of Empirical Finance, Elsevier, vol. 18(1), pages 136-146, January.
    17. Smith, Daniel R., 2007. "Conditional coskewness and asset pricing," Journal of Empirical Finance, Elsevier, vol. 14(1), pages 91-119, January.
    18. Balduzzi, Pierluigi & Robotti, Cesare, 2008. "Mimicking Portfolios, Economic Risk Premia, and Tests of Multi-Beta Models," Journal of Business & Economic Statistics, American Statistical Association, vol. 26, pages 354-368.
    19. DeRoon, Frans A. & Nijman, Theo E., 2001. "Testing for mean-variance spanning: a survey," Journal of Empirical Finance, Elsevier, vol. 8(2), pages 111-155, May.
    20. Ayadi, Mohamed A. & Kryzanowski, Lawrence, 2005. "Portfolio performance measurement using APM-free kernel models," Journal of Banking & Finance, Elsevier, vol. 29(3), pages 623-659, March.
    21. Ahn, Seung C. & Gadarowski, Christopher, 2004. "Small sample properties of the GMM specification test based on the Hansen-Jagannathan distance," Journal of Empirical Finance, Elsevier, vol. 11(1), pages 109-132, January.
    22. Abel, Ernest & Fletcher, Jonathan, 2004. "An empirical examination of UK emerging market unit trust performance," Emerging Markets Review, Elsevier, vol. 5(4), pages 389-408, December.
    23. repec:kap:rqfnac:v:50:y:2018:i:1:d:10.1007_s11156-017-0627-z is not listed on IDEAS
    24. Guermat, Cherif & Freeman, Mark C., 2010. "A net beta test of asset pricing models," International Review of Financial Analysis, Elsevier, vol. 19(1), pages 1-9, January.
    25. Wolfgang Bessler & Wolfgang Drobetz & Heinz Zimmermann, 2007. "Conditional Performance Evaluation for German Mutual Equity Funds," Working papers 2007/22, Faculty of Business and Economics - University of Basel.

    More about this item


    Access and download statistics


    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:bla:jfinan:v:54:y:1999:i:4:p:1221-1248. See general information about how to correct material in RePEc.

    For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: (Wiley-Blackwell Digital Licensing) or (Christopher F. Baum). General contact details of provider: .

    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 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.

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

    IDEAS is a RePEc service hosted by the Research Division of the Federal Reserve Bank of St. Louis . RePEc uses bibliographic data supplied by the respective publishers.