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Atlanta Fed Working Papers

Specification Tests of Asset Pricing Models Using Excess Returns

Raymond Kan and Cesare Robotti
Working Paper 2006-10
August 2006

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We discuss the impact of different formulations of asset pricing models on the outcome of specification tests that are performed using excess returns. It is generally believed that when only excess returns are used for testing asset pricing models, the mean of the stochastic discount factor (SDF) does not matter. We show that the mean of the candidate SDF is only irrelevant when the model is correct. When the model is misspecified, the mean of the SDF can be a very important determinant of the specification test statistic, and it also heavily influences the relative rankings of competing asset pricing models. We point out that the popular way of specifying the SDF as a linear function of the factors is problematic because the specification test statistic is not invariant to an affine transformation of the factors and the SDFs of competing models can have very different means. In contrast, an alternative specification that defines the SDF as a linear function of the de-meaned factors is free from these two problems and is more appropriate for model comparison. In addition, we suggest that a modification of the traditional Hansen-Jagannathan distance (HJ distance) is needed when only excess returns are used. The modified HJ distance uses the inverse of the covariance matrix (instead of the second moment matrix) of excess returns as the weighting matrix to aggregate pricing errors. We provide asymptotic distributions of the modified HJ distance and of the traditional HJ distance based on the de-meaned SDF under the correctly specified model and the misspecified models. Finally, we propose a simple methodology for computing the standard errors of the estimated SDF parameters that are robust to model misspecification.

JEL classification: G12

Key words: Hansen-Jagannathan distance, excess returns, stochastic discount factors

The authors thank Pierluigi Balduzzi, Mark Fisher, Nikolay Gospodinov, Chris Kirby, Jay Shanken, Paula Tkac, Kevin Wang, Chu Zhang, Guofu Zhou, seminar participants at Concordia University and Singapore Management University, and participants at the 2006 Topics in Financial Econometrics Conference at the Federal Reserve Bank of Atlanta for helpful discussions and comments. Kan gratefully acknowledges financial support from the National Bank Financial of Canada. 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 Raymond Kan, Joseph L. Rotman School of Management, University of Toronto, 105 St. George Street, Toronto, Ontario, Canada M5S 3E6, 416-978-4291,, or Cesare Robotti, Federal Reserve Bank of Atlanta, Research Department, 1000 Peachtree Street, N.E., Atlanta, GA 30303, 404-498-8543,

For further information, contact the Public Affairs Department, Federal Reserve Bank of Atlanta, 1000 Peachtree Street, N.E., Atlanta, Georgia 30309-4470, 404-498-8020.