A critique of the stochastic discount factor methodology

Authors
Citation
R. Kan et Gf. Zhou, A critique of the stochastic discount factor methodology, J FINANCE, 54(4), 1999, pp. 1221-1248
Citations number
21
Categorie Soggetti
Economics
Journal title
JOURNAL OF FINANCE
ISSN journal
00221082 → ACNP
Volume
54
Issue
4
Year of publication
1999
Pages
1221 - 1248
Database
ISI
SICI code
0022-1082(199908)54:4<1221:ACOTSD>2.0.ZU;2-F
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 fr om the SDF methodology is unreliable. The second problem is that the specif ication test under the SDF methodology has very low power in detecting miss pecified models. Traditional methodologies typically incorporate a fully sp ecified model for asset returns, and they can perform substantially better than the SDF methodology.