GMM tests of stochastic discount factor models with useless factors

This paper studies generalized method of moments tests for the stochastic d iscount factor representation of asset pricing models when one of the propo sed factors is in fact useless, defined as being independent of the asset r eturns. Analytic results on asymptotic distributions and simulation results on finite sample distributions both show that(i) the Wald test tends to ov erreject the hypothesis of a zero factor premium for a useless factor when the model is misspecified, (ii) with the presence of a useless factor, the power of the over-identifying restriction test in rejecting misspecified mo dels is reduced, and in some cases a misspecified model with a useless fact or is more likely to be accepted than the true model. (C) 1999 Elsevier Sci ence S.A. All rights reserved.