Evaluating Asset-Pricing Models Using The Hansen-Jagannathan Bound: A Monte Carlo Investigation

Christopher Otrok, B Ravikumar and Charles Whiteman ()

Working Papers from University of Iowa, Department of Economics

Abstract: We conduct Monte Carlo experiments to examine whether the Hansen and Jagannathan (1991) bound is a useful device for evaluating asset pricing models. Specifically, we use recently developed statistical tests, which are based on a 'distance' between the model and the Hansen-Jagannathan bound, to compute the rejection rates of true models. We first demonstrate that previous Monte Carlo assessments suffer from subtle computational and conceptual errors. We then provide correct finite-sample critical values for asset pricing models with time separable preferences, and show how they depend upon nuisance parameters-risk aversion and the rate of time preference. Further, we show that the finite-sample distribution of the test statistic associated with the risk-neutral case is extreme, in the sense that critical values based on this distribution will deliver type I errors no larger than intended-regardless of risk aversion or the rate of time preference. Extending the analysis to accommodate other preferences, we show that in the state non-separable case, the small-sample distributions of the test statistics are influenced significantly by the degree of intertemporal substitution, but not by attitudes toward risk. For habit formation preferences, the small sample distributions are strongly influenced by the habit parameter. However, the maximal size critical values for time-separable preferences are appropriate for habit formation as well as state non-separable preferences. We conclude that with these critical values the HJ bound is indeed a useful evaluation device.

Keywords: Equity Premium; Asset Pricing; Spectral Analysis (search for similar items in EconPapers)
JEL-codes: E21 E43 G12 (search for similar items in EconPapers)
Pages: 31 pages
Date: 1998-08, Revised 1999-01
References: Add references at CitEc
Citations: View citations in EconPapers (1)

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Related works:
Journal Article: Evaluating asset-pricing models using the Hansen-Jagannathan bound: a Monte Carlo investigation (2002)
Working Paper: Evaluating Asset-Pricing Models Using The Hansen-Jagannathan Bound: A Monte Carlo Investigation (2000)
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Persistent link: https://EconPapers.repec.org/RePEc:uia:iowaec:99-01

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