A Critique of the Stochastic Discount Factor Methodology

A Critique of the Stochastic Discount Factor Methodology

  • Raymond Kan
  • Guofu Zhou

Article first published online: 17th December 2002 DOI: 10.1111/0022-1082.00145

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.

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