Assessing Misspecifications in Asset Pricing Models with Nonlinear Projections of Pricing Kernels

39 Pages Posted: 3 Mar 2010

See all articles by Caio Almeida

Caio Almeida

Getulio Vargas Foundation ; Princeton University

René Garcia

Université de Montréal - CIREQ - Département de sciences économiques; University of Montreal

Multiple version iconThere are 2 versions of this paper

Date Written: February 25, 2010

Abstract

We develop a new approach to evaluate asset pricing models (APMs) based on Minimum Discrepancy (MD) projections that generalize the Hansen-Jagannathan (HJ, 1997) distance to account for an arbitrary number of moments of asset returns. The Minimum Discrepancy projections correct APMs to become admissible stochastic discount factors (SDF) through nonlinear functions of the basis assets returns, contrasting with the linear corrections from the HJ method. These nonlinear corrections make our method more effective than available methods in detecting sources of model specifications, specially in economies with nonlinear priced risk, or when the APMs being tested contain nonlinear functions of basis assets. We provide a geometric interpretation and also a theoretical example to illustrate our point. In the example, the CAPM is diagnosed in an economy where the true SDF prices coskewness risk with respect to the market portfolio (Kraus and Litzemberger (1976)). It is shown that while methods that use the HJ distance can not identify the correct source of misspecification of the CAPM in this economy (a quadratic term in the market return), there are nonlinear projections in the class of MD problems that correctly capture the misspecified term. Also, in order to explore the empirical structure of the MD projections, we provide a full example of estimation and diagnosis of the CCAPM model based on several discrepancy measures.

Keywords: Asset Pricing Proxies, Euler Equations, Minimum Discrepancy Estimators, Model Selection

JEL Classification: C1, C5, G1

Suggested Citation

Almeida, Caio and Garcia, René, Assessing Misspecifications in Asset Pricing Models with Nonlinear Projections of Pricing Kernels (February 25, 2010). Available at SSRN: https://ssrn.com/abstract=1559360 or http://dx.doi.org/10.2139/ssrn.1559360

Caio Almeida (Contact Author)

Getulio Vargas Foundation ( email )

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HOME PAGE: http://www.fgv.br/professor/calmeida/

Princeton University ( email )

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René Garcia

Université de Montréal - CIREQ - Département de sciences économiques ( email )

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Montreal, Quebec H3C 3J7
Canada
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University of Montreal ( email )

United States

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