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Assessing specification errors in stochastic discount factor models

  • Lars Peter Hansen
  • Ravi Jagannathan

In this paper we develop alternative ways to compare asset pricing models when it is understood that their implied stochastic discount factors do not price all portfolios correctly. Unlike comparisons based on chi-squared statistics associated with null hypotheses that models are correct, our measures of model performance do not reward variability of discount factor proxies. One of our measures is designed to exploit fully the implications of arbitrage-free pricing of derivative claims. We demonstrate empirically the usefulness of methods in assessing some alternative stochastic factor models that have been proposed in asset pricing literature.

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Paper provided by Federal Reserve Bank of Minneapolis in its series Staff Report with number 167.

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Date of creation: 1994
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Handle: RePEc:fip:fedmsr:167
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