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Smart Stochastic Discount Factors

Author

Listed:
  • Sofonias A. Korsaye

    (University of Geneva - Geneva Finance Research Institute (GFRI); Swiss Finance Institute)

  • Alberto Quaini

    (University of Geneva)

  • Fabio Trojani

    (Swiss Finance Institute; University of Geneva)

Abstract

We propose a novel no-arbitrage framework, which exploits convex asset pricing constraints to study investors’ marginal utility of wealth or, more generally, Stochastic Discount Factors (SDFs). We establish a duality between minimum dispersion SDFs and penalized portfolio selection problems, building the foundation for characterizing the feasible tradeoffs between a SDF’s pricing accuracy and its comovement with systematic risks. Empirically, a minimum variance CAPM–SDF produces a Pareto optimal tradeoff. This SDF only depends on two distinct risk factors: A traded market factor and a minimum variance excess return that bounds the mispricing of risks unspanned by market shocks.

Suggested Citation

  • Sofonias A. Korsaye & Alberto Quaini & Fabio Trojani, 2021. "Smart Stochastic Discount Factors," Swiss Finance Institute Research Paper Series 21-51, Swiss Finance Institute.
    • Handle: RePEc:chf:rpseri:rp2151
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    File URL: https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3878300
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    Cited by:

    1. Marine Carrasco & N'Golo Koné, 2023. "Test for Trading Costs Effect in a Portfolio Selection Problem with Recursive Utility," CIRANO Working Papers 2023s-03, CIRANO.

    More about this item

    Keywords

    SDF; Convex Pricing Constraints; Minimum Dispersion SDF; Market Frictions; SDF regularization; Arbitrage Pricing Theory;
    All these keywords.

    JEL classification:

    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates

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