Financial Markets and Asset Pricing

Essentially all modern asset pricing models rely on a single fundamental pricing equation according to which the price of an asset follows the relationship 2.1 $${P}_{i,t} = {E}_{t}[{M}_{t+1}{X}_{i,t+1}]$$ where Pi, tis the price of an asset iat time t, Mt+ 1is the stochastic discount factor (SDF) and Xi, t+ 1represents the payoff of asset iat t+ 1. Payoffs in general can be split up into a future price component (Pi, t+ 1) and an earning stream (Di, t+ 1) such as coupon payments on coupon-bearing bonds or dividends on stocks. Since future payoffs are uncertain, the SDF is used to value the state-contingent possible payoffs of the asset in t+ 1 so that the SDF takes the uncertain payoff back to present. But even if the cash flows generated by asset imay be known with certainty, the discount factors and future interest rates respectively are uncertain numbers depending on the future state of the economy.