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Testing asset pricing models with Euler equations: it's worse than you think

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  • Christopher J. Neely

Abstract

This paper reexamines the small sample properties of Hansen's (1982) Generalized Method of Moments (GMM) and Hansen and Jagannathan's (1989) estimation-free tests on simulated data from a more plausible consumption based asset pricing model. Previous studies are incomplete and misleading. A continuous distribution of consumption growth produces a near nonidentification in the GMM criterion function, severe bias in coefficient estimates, misleading parameter confidence intervals even for very large samples and far worse overrejection problem in GMM tests of restriction than previously thought. Further, estimation-free methods advocated by Kocherlakota (1990) may also have very poor finite sample properties.

Suggested Citation

  • Christopher J. Neely, 1995. "Testing asset pricing models with Euler equations: it's worse than you think," Working Papers 1995-018, Federal Reserve Bank of St. Louis.
  • Handle: RePEc:fip:fedlwp:1995-018
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    References listed on IDEAS

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    1. Mehra, Rajnish & Prescott, Edward C., 1985. "The equity premium: A puzzle," Journal of Monetary Economics, Elsevier, vol. 15(2), pages 145-161, March.
    2. Hansen, Lars Peter, 1982. "Large Sample Properties of Generalized Method of Moments Estimators," Econometrica, Econometric Society, vol. 50(4), pages 1029-1054, July.
    3. 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.
    4. 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.
    5. Burnside, Craig, 1994. "Hansen-Jagannathan Bounds as Classical Tests of Asset-Pricing Models," Journal of Business & Economic Statistics, American Statistical Association, vol. 12(1), pages 57-79, January.
    6. Kocherlakota, Narayana R., 1990. "On tests of representative consumer asset pricing models," Journal of Monetary Economics, Elsevier, vol. 26(2), pages 285-304, October.
    7. Lucas, Robert E, Jr, 1978. "Asset Prices in an Exchange Economy," Econometrica, Econometric Society, vol. 46(6), pages 1429-1445, November.
    8. Cecchetti, Stephen G & Lam, Pok-sang & Mark, Nelson C, 1990. "Mean Reversion in Equilibrium Asset Prices," American Economic Review, American Economic Association, vol. 80(3), pages 398-418, June.
    9. Gregory, Allan W. & Smith, Gregor W., 1992. "Sampling variability in Hansen-Jagannathan bounds," Economics Letters, Elsevier, vol. 38(3), pages 263-267, March.
    10. Hansen, Lars Peter & Singleton, Kenneth J, 1982. "Generalized Instrumental Variables Estimation of Nonlinear Rational Expectations Models," Econometrica, Econometric Society, vol. 50(5), pages 1269-1286, September.
    11. Tauchen, George, 1986. "Statistical Properties of Generalized Method-of-Moments Estimators of Structural Parameters Obtained from Financial Market Data," Journal of Business & Economic Statistics, American Statistical Association, vol. 4(4), pages 397-416, October.
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    Keywords

    Prices ; Statistics;

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