Journal of Finance Vol. 54 No. 4 1999

A Critique of the Stochastic Discount Factor Methodology

Raymond Kan^1,2; Guofu Zhou^3,4

¹ The University of Texas at Dallas · ² University of Toronto · ³ Washington University in St. Louis · ⁴ Fanjingshan National Nature Reserve

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.

DOI

10.1111/0022-1082.00145

Volume

54

Issue

4

Pages

1221-1248

Language

en

Sources

openalex crossref

Cite

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