Empirical Evaluation of Asset Pricing Models: Arbitrage and Pricing Errors in Contingent Claims

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Empirical Evaluation of Asset Pricing Models: Arbitrage and Pricing Errors in Contingent Claims

Previous title: Empirical Evaluation of Asset Pricing Models: Arbitrage and Pricing Errors over Contingent Claims

October 2006 Number 265
Revised December 2011

JEL classification: G1, G12

Authors: Zhenyu Wang and Xiaoyan Zhang

Hansen and Jagannathan (1997) have developed two measures of pricing errors for asset pricing models: the maximum pricing error in all static portfolios of the test assets and the maximum pricing error in all contingent claims of the assets. In this paper, we develop simulation-based Bayesian inference for these measures. While the literature reports that the time-varying extensions substantially reduce pricing errors of classic models on the standard test assets, our analysis shows that the reduction is much smaller based on the second measure. Those time-varying models have pricing errors on the contingent claims of the test assets because their stochastic discount factors are often negative and admit arbitrage opportunities.

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