A Theory of Dissimilarity between Stochastic Discount Factors

Abstract

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