Evaluating Asset Pricing Models Using the Second Hansen-Jagannathan Distance

46 Pages Posted: 25 Mar 2008

See all articles by Haitao Li

Haitao Li

University of Michigan - Stephen M. Ross School of Business; Cheung Kong Graduate School of Business; Cheung Kong Graduate School of Business

Yuewu Xu

Teachers Insurance and Annuity Association College Retirement Equities Fund (TIAA-CREF)

Xiaoyan Zhang

Tsinghua University - PBC School of Finance

Date Written: March 2008

Abstract

We develop a systematic approach for evaluating asset pricing models based on the second Hansen-Jagannathan distance (HJD), which requires a good asset pricing model to not only have small pricing errors but also be arbitrage free. Our approach includes a specification test and a sequence of model selection procedures for non-nested, overlapping, and nested models. While the former can test whether a given model is correctly specified, the latter can compare relative performances of potentially misspecified models. Our methods are more powerful than existing ones in (i) detecting misspecified models that have small pricing errors but are not arbitrage free; and (ii) differentiating models that have similar pricing errors of a given set of test assets. Simulation studies show that our tests have reasonably good finite sample performances for typical sample sizes considered in the literature. Using the Fama-French size and book-to-market portfolios or hedge fund portfolios that exhibit option-like returns, we reach dramatically different conclusions on model performances based on our approach and existing methods.

Keywords: Stochastic Discount Factor, Specification Tests, Model Selection, HJ distance, Arbitrage

JEL Classification: C4, C5, G1

Suggested Citation

Li, Haitao and Xu, Yuewu and Zhang, Xiaoyan, Evaluating Asset Pricing Models Using the Second Hansen-Jagannathan Distance (March 2008). Available at SSRN: https://ssrn.com/abstract=1107054 or http://dx.doi.org/10.2139/ssrn.1107054

Haitao Li

University of Michigan - Stephen M. Ross School of Business ( email )

701 Tappan Street
Ann Arbor, MI MI 48109
United States
734-615-5475 (Phone)

Cheung Kong Graduate School of Business ( email )

Oriental Plaza, Tower E3
One East Chang An Avenue
Beijing, 100738
China

Cheung Kong Graduate School of Business ( email )

Oriental Plaza, Tower E3
One East Chang An Avenue
Beijing, 100738
China

Yuewu Xu

Teachers Insurance and Annuity Association College Retirement Equities Fund (TIAA-CREF) ( email )

730 Third Avenue
New York, NY 10017-3206
United States

Xiaoyan Zhang (Contact Author)

Tsinghua University - PBC School of Finance ( email )

No. 43, Chengdu Road
Haidian District
Beijing 100083
China

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