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Asset Pricing with Observable Stochastic Discount Factors

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Author Info
Peter N Smith
Michael R Wickens

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Abstract

The stochastic discount factor model provides a general framework for pricing assets. By specifying the discount factor suitably it encompasses most of the theories currently in use, including CAPM and consumption CAPM. The SDF model has been based on the use of single and multiple factors, and on latent and observed factors. In most situations, and especially for the term structure, single factor models are inappropriate, whilst latent variables require the somewhat arbitrary specification of generating processes and are difficult to interpret. In this paper we survey the principal different implementations of the SDF model for FOREX, equity and bonds and we propose a new approach. This is based on the use of multiple factors that are observable and modelling the joint distribution of excess returns and the factors using a multi-variate GARCH-in-mean process. We argue that in general single equation and VAR models, although widely used in empirical finance, are inappropriate as they do not satisfy the no-arbitrage condition. Since risk premia arise from conditional covariation between returns and the factors, both a multi-variate context and having conditional covariances in the conditional mean process, is essential. We explain how apparent exceptions, such as the CIR and Vasicek models, in fact meet this requirement - but at a price. We explain our new approach, discuss how it might be implemented and present some empirical evidence, mainly from our own researches. Partly, to enable comparisons to be made, the survey also includes evidence from recent empirical work using more traditional approaches.

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Paper provided by Department of Economics, University of York in its series Discussion Papers with number 02/03.

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Related research
Keywords: Asset Pricing; Stochastic Discount Factors; Forex; Equity Term Structure; Affine Factor Models; Consumption CAPM; Financial Econometrics; GARCH;

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Find related papers by JEL classification:
G12 - Financial Economics - - General Financial Markets - - - Asset Pricing
C51 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Model Construction and Estimation

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Full references

Cited by:
(explanations, Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.)

  1. Alexandros Kostakis, 2007. "Mind Coskewness: A Performance Measure for Prudent, Long-Term Investors," Discussion Papers 07/07, Department of Economics, University of York. [Downloadable!]
  2. P N Smith & S Sorensen & M R Wickens, . "An Asset Market Integration Test Based on Observable Macroeconomic Stochastic Discount Factors," Discussion Papers 03/14, Department of Economics, University of York. [Downloadable!]
  3. Tigran Poghosyan & Evzen Kocenda, 2006. "Foreign Exchange Risk Premium Determinants: Case of Armenia," William Davidson Institute Working Papers Series wp811, William Davidson Institute at the University of Michigan Stephen M. Ross Business School. [Downloadable!]
    Other versions:
  4. Peter Spencer, 2004. "Affine Macroeconomic Models of the Term Structure of Interest Rates: The US Treasury Market 1961-99," Discussion Papers 04/16, Department of Economics, University of York, revised Jan 2006. [Downloadable!]
  5. Smith, Peter N & Sorensen, Steffen & Wickens, Michael R., 2009. "The Equity Premium and the Business Cycle: the Role of Demand and Supply Shocks," CEPR Discussion Papers 7227, C.E.P.R. Discussion Papers. [Downloadable!] (restricted)
  6. P N Smith & S Sorensen & M R Wickens, . "Macroeconomic Sources of Equity Risk," Discussion Papers 03/13, Department of Economics, University of York. [Downloadable!]
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