A Unifying Approach to the Empirical Evaluation of Asset Pricing Models

Abstract

Two main approaches are commonly used to empirically evaluate linear factor pricing models: regression and SDF methods, with centred and uncentred versions of the latter. We show that unlike standard two-step or iterated GMM procedures, single-step estimators such as continuously updated GMM 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 not, or the use of excess or gross returns. We illustrate our results with the currency returns constructed by Lustig and Verdelhan (2007).

Keywords: CU-GMM, factor pricing models, forward premium puzzle, generalised empirical likelihood, stochastic discount factor

JEL Classification: G11, G12, C12, C13