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State Price Deflators and Stochastic Discounting

Author

Listed:
  • Mario V. Wüthrich

    (ETH Zurich)

  • Michael Merz

    (University of Hamburg)

Abstract

In this chapter we describe stochastic discounting and valuation of random cash flows in a multiperiod discrete time setting. We therefore start by introducing the term structure of interest rates notion. We briefly discuss the calibration of the actual risk-free interest rate curve using the Svensson and the Nelson–Siegel term structure families. The main purpose of this chapter is then to introduce a consistent multiperiod pricing framework. This consistent multiperiod pricing framework is either based on state price deflators or on equivalent martingale measures which, in particular, lead to a pricing framework free of arbitrage. We introduce these concepts and describe their connection using the market price of risk construction. In fact, we insist of understanding price processes under both concepts (and their connection) because calibration, prediction and pricing consider both frameworks simultaneously.

Suggested Citation

Handle: RePEc:spr:sprfcp:978-3-642-31392-9_2
DOI: 10.1007/978-3-642-31392-9_2
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