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Volatility of the Stochastic Discount Factor, and the Distinction between Risk-Neutral and Objective Probability Measures

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Author Info
Bakshi, Gurdip () (Smith School of Business)
Chen, Zhiwu () (Yale School of Management)
Hjalmarsson, Erik () (Department of Economics)
Abstract

This paper derives a measure that characterizes the distance between the risk-neutral and the objective probability measures for any candidate asset pricing model. We formally show that the distance metric is equal to the volatility of the stochastic discount factor. This theoretical result gives an alternative interpretation to the Hansen-Jagannathan bounds: they provide a lower bound for the distance between the objective and the risk-neutral probability measures. Our empirical application provides support for the notion that the crash of 1987 has widened the wedge between the risk-neutral and the objective probability measures.

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File URL: http://hdl.handle.net/2077/2766
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Paper provided by Göteborg University, Department of Economics in its series Working Papers in Economics with number 159.

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Length: 23 pages
Date of creation: 02 Feb 2005
Date of revision:
Handle: RePEc:hhs:gunwpe:0159

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Postal: Department of Economics, School of Business, Economics and Law, Göteborg University Box 640, SE 405 30 GÖTEBORG, Sweden
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Related research
Keywords: Risk-neutral measures; objective probability measures; volatility of the stochastic discount factor; no-arbitrage; Hansen-Jagannathan bounds;

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Find related papers by JEL classification:
G10 - Financial Economics - - General Financial Markets - - - General (includes Measurement and Data)

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    Other versions:
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  6. Breeden, Douglas T & Litzenberger, Robert H, 1978. "Prices of State-contingent Claims Implicit in Option Prices," Journal of Business, University of Chicago Press, vol. 51(4), pages 621-51, October. [Downloadable!] (restricted)
  7. Mehra, Rajnish & Prescott, Edward C., 2003. "The equity premium in retrospect," Handbook of the Economics of Finance, in: G.M. Constantinides & M. Harris & R. M. Stulz (ed.), Handbook of the Economics of Finance, edition 1, volume 1, chapter 14, pages 889-938 Elsevier. [Downloadable!] (restricted)
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  8. Hansen, Lars Peter & Jagannathan, Ravi, 1997. " Assessing Specification Errors in Stochastic Discount Factor Models," Journal of Finance, American Finance Association, vol. 52(2), pages 557-90, June. [Downloadable!] (restricted)
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  9. Rosenberg, Joshua V. & Engle, Robert F., 2002. "Empirical pricing kernels," Journal of Financial Economics, Elsevier, vol. 64(3), pages 341-372, June. [Downloadable!] (restricted)
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  10. Campbell, John Y., 2003. "Consumption-based asset pricing," Handbook of the Economics of Finance, in: G.M. Constantinides & M. Harris & R. M. Stulz (ed.), Handbook of the Economics of Finance, edition 1, volume 1, chapter 13, pages 803-887 Elsevier. [Downloadable!] (restricted)
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  11. Mehra, Rajnish & Prescott, Edward C., 1985. "The equity premium: A puzzle," Journal of Monetary Economics, Elsevier, vol. 15(2), pages 145-161, March. [Downloadable!] (restricted)
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