Francisco Peñaranda and Enrique Sentana
CenFIS Working Paper 10-03
Two main approaches are commonly used to empirically evaluate linear factor pricing models: regression and stochastic discount factor (SDF) methods, with centered and uncentered versions of the latter. We show that unlike standard two-step or iterated gerneralized method of moments (GMM) procedures, single-step estimators such as continuously updated GMMs yield numerically identical values for prices of risk, pricing errors, Jensen's alphas, and overidentifying restrictions tests irrespective of the model validity. Therefore, there is arguably a single approach regardless of the factors being traded or the use of excess or gross returns. We illustrate our results with the currency returns constructed by Lustig and Verdelhan (2007).
JEL classification: G11, G12, C12, C13
Key words: CU-GMM, factor pricing models, forward premium puzzle, generalized empirical likelihood, stochastic discount factor
The authors thank Abhay Abhyankar, Manuel Arellano, Antonio Díez de los Ríos, Lars Hansen, Raymond Kan, Craig MacKinlay, Cesare Robotti, Rosa Rodríguez, Amir Yaron, participants at the XVIII Finance Forum (Elche) and the XXXV Simposio de la Asociación Española de Economía (Madrid), and audiences at the Atlanta Fed, Princeton University, Universitat Pompeu Fabra, and the Wharton School for helpful comments, suggestions, and discussions. Financial support from the Spanish Ministry of Science and Innovation through grants ECO 2008-03066 (Peñaranda) and ECO 2008-00280 (Sentana) is gratefully acknowledged. Peñaranda also acknowledges the financial support of the Barcelona GSE and the Government of Catalonia and the hospitality of the Center for Financial Innovation and Stability at the Atlanta Fed. The views expressed here are the authors' and not necessarily those of the Federal Reserve Bank of Atlanta or the Federal Reserve System. Any remaining errors are the authors' responsibility.
Please address questions regarding content to Francisco Peñaranda, Assistant Professor, Department of Economics and Business, Universitat Pompeu Fabra, Ramon Trias Fargas 25-27, 08005 Barcelona, Spain, (+34) 93 542 2638, fax (+34) 93 542 1746, firstname.lastname@example.org, or Enrique Sentana, CEMFI, Casado del Alisal 5, 28014 Madrid, Spain, +34 914290551, fax +34 914291056, email@example.com.
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