Computational Issues in the Stochastic Discount Factor Framework for Equity Risk Premium

21 Pages Posted: 19 Nov 2013

See all articles by Ramaprasad Bhar

Ramaprasad Bhar

UNSW Business School, Risk and Actuarial Studies

A. (Tassos) G. Malliaris

Loyola University of Chicago - Department of Economics

Date Written: November 18, 2013

Abstract

The Stochastic Discount Factor (SDF) methodology is a general and convenient framework for asset pricing. SDF encapsulates all the modeling uncertainties and its advantage is that we do not require the knowledge of investors’ preferences. Suitable specification of SDF is, therefore, critical. It has been based on single or multiple factors and also on observable factors as well as latent factors. The variables required to proxy for the factors may be both macroeconomic as well as behavioral. In this article we show how we can incorporate such variables for empirical implementation of equity risk premium with daily frequency. Practical issues crop up to define the dependence between the asset return and the SDF. Here we show how copula can be used in this context and solve some of the analytical complexities for software implementation.

Keywords: Equity premium, Stochastic discount factor, Daily frequency, Momentum, Copula

JEL Classification: C22, E44, G12

Suggested Citation

Bhar, Ramaprasad and Malliaris, A. (Tassos) G., Computational Issues in the Stochastic Discount Factor Framework for Equity Risk Premium (November 18, 2013). Available at SSRN: https://ssrn.com/abstract=2356602 or http://dx.doi.org/10.2139/ssrn.2356602

Ramaprasad Bhar

UNSW Business School, Risk and Actuarial Studies ( email )

Sydney, NSW 2052
Australia

A. (Tassos) G. Malliaris (Contact Author)

Loyola University of Chicago - Department of Economics ( email )

16 E. Pearson Ave
Quinlan School of Business
Chicago, IL 60611
United States
312-915-6063 (Phone)

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