The Journal of Finance

The Journal of Finance publishes leading research across all the major fields of finance. It is one of the most widely cited journals in academic finance, and in all of economics. Each of the six issues per year reaches over 8,000 academics, finance professionals, libraries, and government and financial institutions around the world. The journal is the official publication of The American Finance Association, the premier academic organization devoted to the study and promotion of knowledge about financial economics.

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Assessing Specification Errors in Stochastic Discount Factor Models

Published: 04/18/2012   |   DOI: 10.1111/j.1540-6261.1997.tb04813.x

LARS PETER HANSEN, RAVI JAGANNATHAN

In this article we develop alternative ways to compare asset pricing models when it is understood that their implied stochastic discount factors do not price all portfolios correctly. Unlike comparisons based on χ2 statistics associated with null hypotheses that models are correct, our measures of model performance do not reward variability of discount factor proxies. One of our measures is designed to exploit fully the implications of arbitrage‐free pricing of derivative claims. We demonstrate empirically the usefulness of our methods in assessing some alternative stochastic factor models that have been proposed in asset pricing literature.


Misspecified Recovery

Published: 02/29/2016   |   DOI: 10.1111/jofi.12404

JAROSLAV BOROVIČKA, LARS PETER HANSEN, JOSÉ A. SCHEINKMAN

Asset prices contain information about the probability distribution of future states and the stochastic discounting of those states as used by investors. To better understand the challenge in distinguishing investors' beliefs from risk‐adjusted discounting, we use Perron–Frobenius Theory to isolate a positive martingale component of the stochastic discount factor process. This component recovers a probability measure that absorbs long‐term risk adjustments. When the martingale is not degenerate, surmising that this recovered probability captures investors' beliefs distorts inference about risk‐return tradeoffs. Stochastic discount factors in many structural models of asset prices have empirically relevant martingale components.