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Evaluating Asset Pricing Models in a Fama-French Framework

Author

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  • Carlos Enrique Carrasco Gutierrez
  • Wagner Piazza Gaglianone

Abstract

In this work we propose a methodology to compare different stochastic discount factor (SDF) proxies based on relevant market information. The starting point is the work of Fama and French, which evidenced that the asset returns of the U.S. economy could be explained by relative factors linked to characteristics of the firms. In this sense, we construct a Monte Carlo simulation to generate a set of returns perfectly compatible with the Fama and French factors and, then, investigate the performance of different SDF proxies. Some goodness-of-fit statistics and the Hansen and Jagannathan distance are used to compare asset pricing models. An empirical application of our setup is also provided.

Suggested Citation

  • Carlos Enrique Carrasco Gutierrez & Wagner Piazza Gaglianone, 2008. "Evaluating Asset Pricing Models in a Fama-French Framework," Working Papers Series 175, Central Bank of Brazil, Research Department.
  • Handle: RePEc:bcb:wpaper:175
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    File URL: http://www.bcb.gov.br/pec/wps/ingl/wps175.pdf
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    References listed on IDEAS

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    1. Wayne E. Ferson & Campbell R. Harvey, 1999. "Conditioning Variables and the Cross Section of Stock Returns," Journal of Finance, American Finance Association, vol. 54(4), pages 1325-1360, August.
    2. Raymond Kan & Cesare Robotti, 2009. "Model Comparison Using the Hansen-Jagannathan Distance," Review of Financial Studies, Society for Financial Studies, vol. 22(9), pages 3449-3490, September.
    3. Clive Gaunt, 2004. "Size and book to market effects and the Fama French three factor asset pricing model: evidence from the Australian stockmarket," Accounting and Finance, Accounting and Finance Association of Australia and New Zealand, vol. 44(1), pages 27-44.
    4. Whitney K. Newey & Kenneth D. West, 1994. "Automatic Lag Selection in Covariance Matrix Estimation," Review of Economic Studies, Oxford University Press, vol. 61(4), pages 631-653.
    5. 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.
    6. John M. Griffin, 2002. "Are the Fama and French Factors Global or Country Specific?," Review of Financial Studies, Society for Financial Studies, vol. 15(3), pages 783-803.
    7. Heber Farnsworth, 2002. "Performance Evaluation with Stochastic Discount Factors," The Journal of Business, University of Chicago Press, vol. 75(3), pages 473-504, July.
    8. Jagannathan, Ravi & Kubota, Keiichi & Takehara, Hitoshi, 1998. "Relationship between Labor-Income Risk and Average Return: Empirical Evidence from the Japanese Stock Market," The Journal of Business, University of Chicago Press, vol. 71(3), pages 319-347, July.
    9. Ferson, Wayne E. & Harvey, Campbell R., 1994. "Sources of risk and expected returns in global equity markets," Journal of Banking & Finance, Elsevier, vol. 18(4), pages 775-803, September.
    10. Fabio Araujo & Joao Victor Issler, 2005. "Estimating the Stochastic Discount Factor without a Utility Function," Computing in Economics and Finance 2005 202, Society for Computational Economics.
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    Cited by:

    1. Edgardo Cayón, 2014. "The Effects of Contagion During the Global Financial Crisis in Government-Regulated and Sponsored Assets in Emerging Markets," PhD Thesis, Finance Discipline Group, UTS Business School, University of Technology, Sydney, number 30.

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