A Critique of the Stochastic Discount Factor Methodology

Raymond Kan and Guofu Zhou
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Raymond Kan: University of Toronto

No 12, CEMA Working Papers from China Economics and Management Academy, Central University of Finance and Economics

Abstract: In this paper, we point out that the widely used stochastic discount factor (SDF) methodology ignores a fully specified model for asset returns. As a result, it suffers from two potential problems when asset returns follow a linear factor model. The first problem is that the risk premium estimate from the SDF methodology is unreliable. The second problem is that the specification test under the SDF methodology has very low power in detecting misspecified models. Traditional methodologies typically incorporate a fully specified model for asset returns, and they can perform substantially better than the SDF methodology.

Pages: 28 pages
Date: 1999
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Citations: View citations in EconPapers (35)

Published in The Journal of Finance, August 1999, Volumn 54, Issue 4, pages 1221-1248

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http://down.aefweb.net/WorkingPapers/w12.pdf (application/pdf)

Related works:
Journal Article: A Critique of the Stochastic Discount Factor Methodology (1999)
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Persistent link: https://EconPapers.repec.org/RePEc:cuf:wpaper:12

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