A DYNAMIC ASSET pricing model is refutable empirically if it restricts the joint distribution of the observable asset prices or returns under study. A wide variety of economic and statistical assumptions have been imposed to arrive at such testable restrictions, depending in part on the objectives and scope of a modeler’s analysis. For instance, if the goal is to price a given cash-flow stream based on agents’ optimal consumption and investment decisions, then a modeler typically needs a fully articulated specification of agents’ preferences, the available production technologies, and the constraints under which agents optimize. On the other hand, if a modeler is concerned with the derivation of prices as discounted cash flows, subject only to the constraint that there be no “arbitrage” opportunities in the economy, then it may be sufficient to specify how the relevant discount factors depend on the underlying risk factors affecting security prices, along with the joint distribution of these factors.
An alternative, typically less ambitious, modeling objective is that of testing the restrictions implied by a particular “equilibrium” condition arising out of an agent’s consumption/investment decision. Such tests can often proceed by specifying only portions of an agent’s intertemporal portfolio problem and examining the implied restrictions on moments of subsets of variables in the model. With this narrower scope often comes some “robustness” to potential misspecification of components of the overall economy that are not directly of interest.
Yet a third case is one in which we do not have a well-developed theory for the joint distribution of prices and other variables and are simply attempting to learn about features of their joint behavior. This case arises, for example, when one finds evidence against a theory, is not sure about how to formulate a better-fitting, alternative theory, and, hence, is seeking a better understanding of the historical relations among key economic variables as guidance for future model construction.