APPROXIMATING THE ASSET PRICING KERNEL

This article tests a simple consumption-based asset pricing model by a pproximating the true asset pricing kernel using low-order orthonormal polynomials based on the model's state variables. Approximated kernel s based solely on next period's consumption growth are not rejected by overall measures of model fit, but they produce statistically and eco nomically large pricing errors. Approximated kernels based on two quar ters of future consumption growth and technology shocks have substanti ally improved overall fit. In particular, the best of these kernels ar e capable of eliminating the small firm effect.