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A Critique of the Stochastic Discount Factor Methodology

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  • Raymond Kan

    (University of Toronto)

  • Guofu Zhou

    (Washington University in St. Louis)

Abstract

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.

Suggested Citation

  • Raymond Kan & Guofu Zhou, 1999. "A Critique of the Stochastic Discount Factor Methodology," CEMA Working Papers 12, China Economics and Management Academy, Central University of Finance and Economics.
    • Handle: RePEc:cuf:wpaper:12
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    References listed on IDEAS

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