A Theory of Dissimilarity between Stochastic Discount Factors
64 Pages Posted: 11 Sep 2017 Last revised: 20 Sep 2017
Date Written: September 19, 2017
This paper proposes a measure of dissimilarity between stochastic discount factors (SDFs) in different economies. The SDFs are made comparable using the respective bond prices as the numeraire. The measure is based on a probability distance metric, is dimensionless, synthesizes features of the risk-neutral distribution of currency returns, and can be extracted from currency option prices. Linking theory to data, our empirical implementation reveals a salient geographical pattern in dissimilarity across 45 pairs of industrialized economies. We compare the dissimilarity between SDFs derived from several international asset pricing models to the empirical analog, offering a new dimension to gauge models.
Keywords: Dissimilarity between SDFs
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