Empirical Evaluation of Asset Pricing Models: A Comparison of the SDF and Beta Methods

The stochastic discount factor (SDF) method provides a unified general framework for econometric analysis of assetpricing models. There have been concerns that, compared to the classical beta method, the generality of the SDF method comes at the cost of efficiency in parameter estimation and power in specification tests. We establish the correct framework for comparing the two methods and show that the SDF method is as efficient as the beta method for estimating risk premiums. Also, the specification test based on the SDF method is as powerful as the one based on the beta method.