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Approximating the Asset Pricing Kernel

David A. Chapman
The Journal of Finance
Vol. 52, No. 4 (Sep., 1997), pp. 1383-1410
Published by: Wiley for the American Finance Association
DOI: 10.2307/2329440
Stable URL: http://www.jstor.org/stable/2329440
Page Count: 28
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Approximating the Asset Pricing Kernel
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Abstract

This article tests a simple consumption-based asset pricing model by approximating the true asset pricing kernel using low-order orthonormal polynomials based on the model's state variables. Approximated kernels based solely on next period's consumption growth are not rejected by overall measures of model fit, but they produce statistically and economically large pricing errors. Approximated kernels based on two quarters of future consumption growth and technology shocks have substantially improved overall fit. In particular, the best of these kernels are capable of eliminating the small firm effect.

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