Specification tests of asset pricing models using excess returns

"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."--Federal Reserve Bank of Atlanta web site.