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A stochastic discount factor approach to asset pricing using panel data asymptotics

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  • Araújo, Fabio
  • Issler, João Victor

Abstract

Using the Pricing Equation in a panel-data framework, we construct a novel consistent estimator of the stochastic discount factor (SDF) which relies on the fact that its logarithm is the 'common feature' in every asset return of the economy. Our estimator is a simple function of asset returns and does not depend on any parametric function representing preferences. The techniques discussed in this paper were applied to two relevant issues in macroeconomics and finance: the first asks what type of parametric preference-representation could be validated by asset-return data, and the second asks whether or not our SDF estimator can price returns in an out-of-sample forecasting exercise. In formal testing, we cannot reject standard preference specifications used in the macro/finance literature. Estimates of the relative risk-aversion coefficient are between 1 and 2, and statistically equal to unity. We also show that our SDF proxy can price reasonably well the returns of stocks with a higher capitalization level, whereas it shows some difficulty in pricing stocks with a lower level of capitalization.

Suggested Citation

  • Araújo, Fabio & Issler, João Victor, 2011. "A stochastic discount factor approach to asset pricing using panel data asymptotics," FGV/EPGE Economics Working Papers (Ensaios Economicos da EPGE) 717, FGV/EPGE - Escola Brasileira de Economia e Finanças, Getulio Vargas Foundation (Brazil).
  • Handle: RePEc:fgv:epgewp:717
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    References listed on IDEAS

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    1. Garcia, Rene & Luger, Richard & Renault, Eric, 2003. "Empirical assessment of an intertemporal option pricing model with latent variables," Journal of Econometrics, Elsevier, vol. 116(1-2), pages 49-83.
    2. Richard Blundell & Martin Browning & Costas Meghir, 1994. "Consumer Demand and the Life-Cycle Allocation of Household Expenditures," Review of Economic Studies, Oxford University Press, vol. 61(1), pages 57-80.
    3. Chapman, David A, 1997. " Approximating the Asset Pricing Kernel," Journal of Finance, American Finance Association, vol. 52(4), pages 1383-1410, September.
    4. Sentana, Enrique, 2004. "Factor representing portfolios in large asset markets," Journal of Econometrics, Elsevier, vol. 119(2), pages 257-289, April.
    5. repec:rim:rimwps:40-07 is not listed on IDEAS
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