Assessing Specification Errors in Stochastic Discount Factor Models
JOURNAL OF FINANCE, Vol 52 No 2, June 1997
Posted: 10 Mar 1997
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 2 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 our methods in assessing some alternative stochastic factor models that have been proposed in asset pricing literature.
JEL Classification: E31
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