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A Critique of the Stochastic Discount Factor Methodology
Author(s) -
Kan Raymond,
Zhou Guofu
Publication year - 1999
Publication title -
the journal of finance
Language(s) - English
Resource type - Journals
SCImago Journal Rank - 18.151
H-Index - 299
eISSN - 1540-6261
pISSN - 0022-1082
DOI - 10.1111/0022-1082.00145
Subject(s) - stochastic discount factor , econometrics , asset (computer security) , risk premium , discounting , stochastic investment model , computer science , capital asset pricing model , point (geometry) , factor analysis , factor (programming language) , economics , mathematical optimization , asset allocation , mathematics , financial economics , finance , portfolio , geometry , computer security , programming language
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.