Assessing Specification Errors in Stochastic Discount Factor Models
Posted: 14 Mar 1996
Date Written: September 1991, Revised November 1995
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-Square statistics associated with null hypotheses that models are correct, our measures of model performance do not reward variability of discount factors. 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 discount factor models that have been proposed in the literature.
JEL Classification: G1, G12, C1, C12, C13, E30
Suggested Citation: Suggested Citation