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- Title
A Critique of the Stochastic Discount Factor Methodology.
- Authors
Kan, Raymond; Zhou, Guofu
- 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.
- Subjects
ASSETS (Accounting); RATE of return; EXPECTED returns; STOCHASTIC analysis; RISK premiums; ECONOMIC models; STATISTICS; METHODOLOGY; PRICING; MATHEMATICAL models of finance; MATHEMATICAL models of investments; MATHEMATICAL models of capital
- Publication
Journal of Finance (Wiley-Blackwell), 1999, Vol 54, Issue 4, p1221
- ISSN
0022-1082
- Publication type
Article
- DOI
10.1111/0022-1082.00145